As GSE and other types of industry reform position the secondary mortgage market for a “do-over” of sorts, keep in mind some of the issues from the original formation of the MBS market that will likely have a role to play this time around, too.

These are basics, but given all the regulatory and other complications in today’s market, I fear sometimes they get lost in the shuffle more than they should be.

Prepayment and extension risk continue to be issues, for example. Prepays and the negative convexity of single-family home mortgages have ever since the outset of the securitized market been challenges for investors.

If Liar’s Poker by Michael Lewis is to be believed, the political appeal of “homeownership,” Wall Street salesmanship and eventually the corresponding herd mentality of investors (more on this later), combined with the creation of CMOs and government-related guarantees, overcame this the first time around.

But as I mentioned before, we seem to be in do-over mode right now. So given that the possibility of allowing, valuing and pricing prepayment penalties for single-family mortgages tends to occasionally but consistently resurface in the MBS market it should be watched for.

Granted, politically, it seems unlikely that any practice consumer advocates have been wary of could gain much traction any time soon. But given that things could change over time and there remains a great interest in courting the “once-bitten, twice shy” investor base as GSE reform and the return of the private-label securitized market are expected to unfold, I think it’s still a ball worth keeping one’s eye on.

A more immediate MBS market concern actually could be extension risk, as one could get locked into relatively low yields at today’s historically low rates if rates rise.

Prices as affected by supply-demand flows of both the partially distressed market for real estate collateralizing loans and the secondary markets for the loans themselves are what will matter here. The key to investment opportunities will be to track these accurately and not get caught up in the herd mentality mentioned before.

Speaking of “distressed” or, let me put that another way, “cheap/undervalued” markets: this certainly was by Lewis’ account in the early days of the MBS market, before it took off, both a challenge and an opportunity. Or at least it was before the herd mentality set in and prices rose.
The distressed market of today has been quite focused on when this opportunity ends and it’s been tricky because of the need to factor in, as I mentioned before, not only the secondary markets for loans and the bonds they collateralize but also the underlying housing market. And these markets, while linked, can differ.

In addition to the challenges in sizing up these markets, there are the supply uncertainties in the private-label securitized market, which has been slow to return.

As I alluded to before, there’s been a wait for interest rates to rise that could play a role in when new private-label deals come back. But, in line with their individual appetites for risk, investors should think hard about what might happen to mortgages in the secondary market when that occurs.

When rates rise, yields certainly also do. But underwriting standards are cyclically more likely to loosen, even with the memory of the recent inordinate downturn relatively fresh.

Think about how that could factor into pricing, as well as how the timing of any recovery in the housing market could influence supply in the secondary mortgage market.

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