An unexpected squeeze on Fannie Mae 8.5s last week created a small market frenzy, as investors noticed a shortage of deliverable to-be-announced supply.

"It's an extraordinary short squeeze," said Art Frank, head of mortgage-backed securities research at Nomura Securities. At one point this week, he said that the March/April roll on Fannie Mae 8.5s was bid at 17/32 and offered at 19/32. With fair value being 6/32, it made the rolls 11 ticks special on the bid side and 13 ticks special on the offered side, he said.

An MBS trader further explained that traders just weren't making that much money out of the deal. "The roll was trading at one point at like 19/32, which is like a one-something cost of funds. Twenty-one-plus is like zero cost of funds, which is basically break-even to failing," he said.

To put this in perspective, just last week, "Fannie Mae 8.5s looked fair adjusting for their strong roll, which at the time was a nine-plus bid for March/April, with carry about 4.25 ticks," said David Montano, director of MBS research at Credit Suisse First Boston.

"We actually thought 8s were cheap relative to 8.5s like a week ago, but that was a bad call," the trader added.

In terms of volume, the outstanding float in Fannie Mae 8.5s is actually less than in Dwarf 7.5s - $5 billion versus $7.6 billion. Of that, the total supply of 1999/2000 Fannie Mae 8.5s is only $830 million. "Only $830 million is bonds you want to deliver TBA," said Frank. "The rest is worth a lot more. So that's kind of an interesting development in the market."

In Nomura's analysis, the 1994-1996 Fannie Mae 8.5s are worth 28 ticks more than the 1999/2000 TBAs, because it's burnt out. "We went through these two big refi waves in 98 and 99 and the efficient refinancers left those pools, so it's worth a considerable premium. So 8.5s are very rich absolutely, and the roll is at incredible levels, so people that own it, ought to roll it," Frank said.

The trader agreed. "We also thought you have to watch out for squeezes in this market, considering it's become a very technical market," he said. "And that's going to be the theme going forward, is you have to be very careful as to what you're short. If you're on the wrong side of something you can just get crushed."

At CSFB, Montano recommends that investors who own Fannie Mae 8.5s "take profits by selling the Fannie Mae 8.5/8s swap in March for 2-20 and buying it back in May for 1-29."

Spreads Are Looking Good

While mortgages have become increasingly wider to Treasurys, it has been a relatively quiet week in anticipation of Friday's announcement of the February unemployment figures.

"Mortgage spreads are relatively wide vis-a-vis Treasurys, but right in line with swaps and agencies, which we're tracking quite closely," Frank said.

Montano agreed. "So far today, cusp and current-coupon 30-year collateral is keeping pace with swaps and agencies - which are a basis point tighter - while discounts look softer," he said. "Fannie Mae 6.5s appear a couple of ticks weaker versus 10-year swaps and agencies. We continue to advocate up-in-coupon trades in 30-years, especially Fannie Mae 8s."

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