Last week the buzzwords changed in the mortgage market as duration hedging picked up.

Lehman Brothers discussed this issue in a report released on Monday. "For the most part, mortgage investors seem to be still focused on extension fears and the sector has done well in the past week's rallying environment," analysts wrote. "However, there has been a significant buildup in call risk for the sector due to overall higher rates as well as a greater proportion of lower coupons in the mortgage universe."

Lehman also compared the duration profile of mortgages at current rate levels to that seen in early June. This was when mortgage rates were about 100 basis points lower. The report said the change in the risk profile of mortgages is "quite striking."

During this period, the convexity in mortgages deteriorated considerably. The firm said that while extension risk has only increased marginally, the significant change is on the call risk side. In terms of extension, for the next 50 basis points rise in rates, Lehman expects the duration of the MBS Index to extend by roughly $250 billion in 10-year equivalents. This is compared to $175 billion 10-year equivalents back in June.

In contrast, in terms of call risk, for the next 50 basis points dip in mortgage rates, the duration of the MBS Index would probably shorten by $275 billion10-years, a huge difference compared to only $85 billion 10-years back in June.

Lehman added that the break-neck speeds in the July prepayment report is another reason why call risk is something that investors should be concerned about right now. For instance, pools with a 150 basis point refinancing incentive prepaid in the 80% CPR level. This is 15% CPR more compared to early this year.

July prepays not a good sign

In a related report, JPMorgan Securities said that the July prepay report as well as the recent rally has put call risk into the forefront of the mortgage sector. "The "safe" rate range for mortgages is becoming increasingly narrow," wrote analysts "as prepayment data indicates deteriorating convexity."

The report said that the prepayment "S-curve" steepened as new 30-year collateral with only 60 basis points of no-cost refinancing incentive prepaid at 70% CPR. Meanwhile, new securities with 50 basis points of disincentive prepaid at 1% CPR.

JPMorgan said that with FNMA 5.5s now trading at above $101, the greatest risk to mortgages is another whipsaw with a continued rally.

Basically, having a whipsaw means that if rates back up, this causes portfolios to be negatively convex, and thus investors would need to adjust the duration of their portfolios. Then if the market rallies - moving to the other direction - after a back-up has occurred, another round of delta-hedging needs to be done, making investors incur another loss after delta hedging the position the first time around.

This is why JPMorgan said that persistent high realized volatility may do more harm to a delta-hedged mortgage portfolio compared to a single rate move. For instance, for a cusp coupon, the report said that convexity hedging cost is usually largest for the initial 100 to 150 basis points of a rate move. The added convexity cost of an additional 100 basis points when rates move in the same direction is relatively low. In other words, two 100 basis points whipsaws would be considerably more expensive to delta hedge compared to a single 200 basis point move.

"As risk of back-to-back-whipsaws grows, we would expect that prudent risk management would require decreasing leverage and/or buying convexity," wrote analysts in the report. "This view is driving much of our short-term relative value outlook."

Some researchers said that hedging concerns have affected even the likes of Fannie Mae. The GSE announced that its duration gap for June was plus six months, results that were obviously not taken very positively by the market. The researchers said that since the market backed up since July, Fannie might be further long the market than it was it was in June. "That definitely hurts them," said an analyst. He said that Fannie bought a significant amount of mortgages last month, and has committed to buying more mortgages going forward. This is not going to be very positive for the GSE.

Discounting call risk

Other analysts said that call risk is not really a factor in the mortgage sector, especially in light of the Mortgage Bankers Association (MBA ) Refinancing Index released last Wednesday that showed a 20% dip week over week, decreasing to 3238.4 from 4047.5 the previous week. The Index was also down 51% month-over-month and was down 65% from its peak.

Aside from this, though the Freddie Mac Survey Rate decreased (to 6.23% from 6.34% the previous week), mortgage rates still remained in the above 6% level, which will make only about 50% of the mortgage universe eligible to refinance. This is compared to a peak of over 90%.

"So any expectation of prepayment vulnerability returning is incorrect in our view," one MBS analyst stated. "Having said that, due to the sheer massive number of applications, we are still likely to see record rates of prepayments in both August and September." The analyst said that until the backlog of applications is worked off, the market would continue to see very fast prepays. However, by the October prepayment report, the market should see significantly slower prepayments.

At current mortgage rates, only about half the universe of Agency passthroughs could be refinanced for a savings of 25 basis points or more, said the analyst. This means that prepayment speeds are back to August 2002 levels, which were significantly slower than those that have been reported in the recent past. Analysts are predicting a 30% slowdown in prepayments.

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