Merrill Lynch's announcement to investors last week that it was dropping its recommended weighting in MBS from 35% to 30% sent shockwaves through the market, especially for investors who benchmark their portfolios against the investment bank's MBS index.

"I view Merrill as very credible, and I respect their opinion," said an MBS investor. "The market is definitely reacting to it."

Citing "a weaker economic backdrop, the potential for lower rates on a global basis and recent relative strength in mortgages, we are dropping our MBS allocation from 35 to 30 versus an index weighting of 33," said Merrill's statement. Sources said that the bank was raising Treasurys to 36 from 31 versus an index weighting of 34. "Mortgages have performed better than anticipated in November given the trend to lower yields and we don't believe... this could be sustained if rates continue to climb... We look for investor sentiment to turn decidedly negative on the sector if mortgage yields drop much below current yields," the statement said.

Based on this announcement there was a good deal of originator selling, which was pressuring spreads.

"Dealers are long paper right now, and they can't sell it back to their clients," said a Street analyst. "People want to back off from their mortgage holdings. But Merrill is not the rule, they are the exception, because most Street firms are still bullish on mortgages. But with this announcement, if somebody is on the fence, they might sell more mortgage stuff."

While the Merrill Lynch is not as much of a bellwether index as the Lehman index is, the bank's message gave investors food for thought last week.

"I am fairly comfortable that we in the MBS market have done a very good job with regard to understanding what our risks are," said Kathleen Foody-Malus, an MBS money manager at Federated Investors. "I must admit that I am happy that the equity market is having its little meltdown. This will force people to look over to bonds. But the question is, when they look over at bonds will they stop at Treasurys or realize that there are other sectors out there?

"Out of all the spread-sector product out there, it has to like us the best."

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