The weakness in the housing sector has the impact of reducing cash-out refinancings resulting from low or negative home price appreciation as well as increasing extension risk.

With these risks, Street analysts have been recommending trades that benefit from housing weakness. For instance, Deutsche Bank analysts recommended several trades that carry investors through the current housing slump. However, Deutsche analysts still suggested a MBS underweight as a result of the sector weakening in the event of a rally and selloff in rates. Deutsche analysts also considered the ongoing supply/demand imbalance.

The first trade idea analysts suggested was to buy 5s and 6.5s (or 7s) versus 5.5s and 6s in 30s. They pointed out that 5s are too far out-of-the-money to be hit by the low cash-out refinance activity, but the higher coupons should be considerably affected. They prefer 6.5s versus 6s, as the latter coupon should continue to trade at a discount if the rate range holds. Analysts noted the declining credit quality from the increased nonagency-to-agency fixed refinancing in premium coupons, which should allow for better call protection in the higher coupons. They also mentioned that the tighter lending standards should aid premium prepayments as well.

A second strategy analysts suggested was going long discount and cusp PACs while selling swaptions. The PACs provided cheap extension protection, they said. For investors that expect volatility to trade in a range or decline, selling volatility can monetize the long volatility position of PACs versus TBAs.

Deutsche analysts also like discount 15/30 swaps. They said that 15s are less leveraged to the housing market and experience faster amortization. As the housing market has slowed, speeds have compressed between the two sectors, and 15-year discounts are prepaying faster than 30s, analysts said.

Seasoned discount collateral has built up equity from the previous strong housing market and so should be less affected the downturn. This means that TBA quality should continue to deteriorate on continued weakening in the housing market. As a result, seasoned discount collateral should outperform TBAs, "since valuation still does not seem to fully reflect this issue," analysts said. But given the seasoned discount collateral's strong performance, analysts are recommending just a modest increase in exposure to this trade currently.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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