The MBS market has been buoyed up by low volatility and demand from banks in 2006. Coming into the new year, whether these positive factors would continue to drive performance is a big question mark. And, like everything else, there is the specter of deteriorating credit that is hovering over the prime market.

One issue that is going to be prominent in 2007, according to MBS analysts, is credit. "I think there's a potential that there might be more issues with originations from some small mortgage lending firms," an MBS analyst said. Even though prime investors are still expected to worry more about prepayment risk rather than credit risk, there is the fact that "although there used to be dividing lines that clearly demarcated the Jumbo, the Alt-A and subprime sectors, you can't just do that anymore. Credit has become a continuum." He said that sometimes what shows up as Alt-A, may look solid based on FICO scores, but there are other factors that might affect the credit of the borrower such as CLTV and the level of documentation. "There is a more layered risk in the mortgage market now, most notably with the non-traditional' loans," he said. Although he downplayed the risks, he pointed out that since the market for credit product has become so widespread with the strong CDO bid in place, there are fears that issues in the subprime market could cascade into the prime side as well, particularly in the Alt-A arena.

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