While the market is currently facing mini rate dips, this should change to a continuous upward tick in rates. Under this scenario, mortgage-backed investors are focused on hedging extension risk.

"We think the best mortgage investment strategy in structured product to employ during times like these is one that involves more predictable and stable cashflows with tight windows and lockout," said Kevin Jackson, vice president at RBC Dain Rauscher in a recent report.

Morgan Stanley, meanwhile, said that many investors have voiced concern on whether specified pools make sense at this point, since pools that are credit-impaired might not prepay as fast compared to generic pools when these are out-of-the-money. So in terms of specifieds, the focus has become seasoning and quantifying extension protection.

"[We] believe that the degree of credit impairment on the loans should still be part of the discussion," wrote analysts at Morgan Stanley. Since differences in prepayment speeds and average life are vital in valuing mortgages, prepayment protection should still have an impact on valuations.

In the report, Morgan Stanley researchers studied the recent prepay behavior of investment properties, low FICO and high LTV pools, focusing on 2002 paper. They found that specified pools, on aggregate, slowed down to speeds that were similar to generics. But this slowdown in prepayments was merely a small fraction of the slowdown seen on generics. This is why the expected average life was less varied on specified products.

The data examined implied that 2002 pools backed by mortgages with loan characteristics mentioned above did not really prepay considerably faster compared to generics after last summer's rate backup. Morgan Stanley questioned whether these loan characteristics are useful as a large portion of the market is trading at a discount.

Researchers presented a relatively simple analysis to argue that prepay protection is still essential under an extension scenario. The analysis showed that particularly credit- impaired buckets slowed less compared to the generic cohorts. Also, in terms of the lower coupons, the extension has been considerably worse on the more generic cohorts compared to the pools that were more prepayment-protected.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

http://www.thomsonmedia.com http://www.asreport.com

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