As the MBS market grows in size and as borrowers become increasingly adept at exercising the refinancing option, the negative convexity in mortgages is beginning to have more of an influence in the bond market as a whole, said analysts.

In a recent report, Countrywide Securities tried to quantify, given interest rate moves, the amount of duration now at risk. The report also estimated the level of rates at which negative convexity would have the most impact.

Countrywide points out that most of the hedging activity happens as a reaction to the fixed-rate agency MBS sector. This portion of the market is roughly 70%, which is equivalent to $2.8 trillion of the total $4.0 trillion in securitized one- to four-family mortgages. In terms of ownership of mortgages, Countrywide estimates from FDIC data that depositories own about $1.1 trillion of MBS. GSEs own about $1.0 trillion of mortgage-backeds and another $0.4 trillion in unsecuritized loans.

Though it is hard to put a figure on how much of the movement in MBS durations is actively hedged (estimates range from 10% to 30% or more), it is useful to look at how different holders of mortgages react differently to changes in interest rates and MBS duration. Countrywide said that the most active hedgers are probably hedge funds and Wall Street trading desks. Meanwhile, the report characterized depositories as "semi-active" while GSEs are somewhere in between.

The report also said that within the $2.8 trillion of fixed-rate agency MBS, the most active hedging usually takes place on new mortgage-backeds close to the current coupon. This is because active hedging groups usually focus on current production issues with the greatest liquidity. Using the same reasoning, analysts believe that active hedging occurs more frequently on conventionals compared to Ginnies.

Countrywide stated that the crux of the convexity effect is from prepayment behavior. Essentially, the more borrowers there are whose refinancing alternative is close to being "at the money," the more the duration of the mortgage market shifts in response to slight changes in interest rates.

For their analysis, Countrywide focused on the sectors in MBS that are the most likely to be actively hedged. These are 30- and 15- year conventional mortgage-backeds such as 30-year coupons 6.0% and below and 15-year coupons 5.5% and below. Analysts said they selected this subset, which comprises roughly $1.5 trillion of the MBS market, because it represents most of the originator production and hedging flows, TBA coupon trading, MBS basis trading and CMO deal production.

Through their analysis, Countrywide found that if rates fall from current levels, the rate of change in active MBS duration would be fairly constant (at between $35 and $40 billion 10-year equivalents for every 10-basis-point rate shift). But if interest rates rise from current levels, this convexity effect starts to diminish as more MBS trades at a discount and extension risk fizzles out.

The report said that if interest rates rise 50 to 60 basis points from levels at the beginning of October, the convexity effect is reduced by roughly one-third. "This result is very interesting in light of the recent selloff, in which the 10-year peaked at 4.60 on Sept. 2," wrote analysts. They said that this is not implying that the market stopped selling off only because the pace of MBS extension slowed. Rather, at a 4.60% yield on the 10-year Treasury, the market reached a point at which the mortgage convexity effect was waning, and factors such as economic performance and monetary policy resumed their normally dominant role.

Countrywide said that the market now appears to be complacent about MBS convexity. It warns, however, that if the rally resumes and pushes the 10-year Treasury back below 4.00% and the 30-year mortgage rate down to around 5.50%, the convexity effect "will be back with a vengeance," wrote analysts.

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