With the macroeconomic environment boding well for mortgages and with MBS technicals remaining solid, investors are entering the new year by approaching the sector with caution against skyrocketing prices.

"I expect that we are going to have a range-bound Treasury market with slightly higher rates leading to lower volatility, which is great for mortgages," said Pete Perrotti, senior vice president and director of MBS at Hartford Investment Management Co. "The problem with mortgages is pricing is pretty heavy, you have Fannie 5.5s trading at 102 4/32s for January settlement. With the prices in the mortgage market so high and with everything so refinanceable, the outlook for the mortgage market is cautious."

Indeed, with the macroeconomic environment being so positive for mortgages, the high prices actually make sense, especially with a range-bound Treasury market, heavy refinancing activity, and with the Fed adopting an accommodative stance on the front end which is great for carry and good for CMO and bank demand. In other words, mortgage technicals are great and fundamentals are decent.

However, there are changing aspects of the mortgage market that will cause it to behave differently going forward. HIMCO is also cautious on the possibility of a market back-up.

"If rates back up and if we go into a bearish environment where you get 5.5s below par again we expect those coupons to pay much slower than they have in recent history," he said.

He explained that if rates blow up and extension risk dominates the mortgage market similar to what happened in 1994 the risks would be much greater than back then because the coupon stack in the mortgage market is currently very compressed (comprised mainly of 5.5% and 6% coupons).

"That side of the market is getting us nervous," said Perrotti. "The Treasury market is in range and as you get to the higher end of the range, you get more and more conversations about extension risk. That's what we are going to be very cautious of. We want to pick up as much carry and yield in a range-bound Treasury market but at the same time be cautious about higher rates, which would probably not happen until late next year."

He explained that in the short term, they still like 5.5s and 6s although 6s are a little bit preferred here, just because of their absolute duration. They are also looking at adding a little bit more structured product, which have slightly less extension risk. This offers some good carry upfront and cashflows are actually more predictable, although they are obviously not locked in. Home equity floaters are also being considered at this point.

Zero percent financing

In a recent report, JPMorgan Securities MBS researchers said that "zero percent financing" may as well be the new mantra for the mortgage market. They cited the fact that Dwarf 5s and GNMA 5.5s rolls have been trading near fail (0% implied financing) for the last few months.

Analysts said that when the rolls are that lucrative, this sort of overrides relative value judgments. It would be very difficult to have a strategy with better total returns than just owning 5.5s and 6s or 15-years and rolling them. They mentioned that this is probably going to be true for at least the next two months.

In this situation current coupons can trade richer than they otherwise would have because the expected return from buying the current coupon TBA is enhanced by the ability to roll it special month after month. So it does tend to richen current coupons versus where people would be willing to pay for them if rolls were at carry or were at fair value.

In addition, it means that for accounts that don't roll, some off-the-run products like low loan balance and low WAC pools would be unnaturally cheap, particularly in 6s because people give up the opportunity to roll. So this actually creates some opportunities for non-roll accounts.

Some analysts said that to a certain extent, the one danger of being in this positive carry environment for so long is that it seems like people are getting too comfortable with carry being king.

"What happens when carry isn't king anymore?" asked a mortgage analyst. "How do we go about making money? I think that is a real question. I think the market may be complacent about the carry trade continuing for the foreseeable future, which it probably will."

However, he said that if-and-when the Fed starts raising rates, this will vanish which actually happened in 1994, although the extent would obviously depend on how aggressively the Fed raises rates.

"In the meantime, it makes things interesting because you can justify a lot of trades that don't make a lot of sense when you could basically roll things at a zero percent cost of funds," he added. "Conversely, it makes it difficult and expensive to short mortgages which is also a factor because if you are trading at fail cost essentially that's just like being short Treasurys when they trade special in the repo market."

"While it's hard to quantify," he concluded, "we're concerned that there's enough system-wide leverage to cause serious dislocations to the MBS market in the event that financing costs rise sharply."

Prepayments and other themes coming into the year

Analysts said that the refi wave will probably continue despite mild slowing in the November reports. Art Frank, head of mortgage research at Nomura Securities International, stated in his recently published outlook piece that due to the unprecedented volume of refinancings in the first half of October last year, some mortgage originators who normally offered 30- and 45-day rate locks to borrowers were actually offering 60- and occasionally 75-day rate locks to October applicants, pushing many of the loan closings into December.

"We expect most of those who locked in October to close their refinancings in December, which we now expect to be the peak prepayment month for the current refinancing wave," Frank wrote. "We expect modest declines from the upcoming December peak in January and February, as January speeds will likely reflect the sub-5,000 levels on the Refinancing Index in the first half of November, while February is usually seasonally slower (mainly for housing turnover, but to a lesser degree for refinancing as well) due to the late December holiday effect in slowing all mortgage application activity, refinancing as well as purchase."

Refinancings are not expected to slow anytime soon. Frank said that according to Nomura's economics department, rates are going to be relatively low and the yield curve is going to be relatively steep for the first three quarters of 2003. If this holds true, a significant slowdown is not expected for at least nine months. Otherwise, refinancings are expected to sputter out more quickly.

Frank also stated that another effect of the yield curve remaining steep and commercial loan demand remaining relatively weak is that banks are going to still have a great demand for short CMOs. This should keep mortgage spreads relatively tight. However, this would change as well with economic recovery. Bank participation in the CMO market would likely diminish, which would lead to some widening of mortgage spreads.

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