Despite favorable technicals in the mortgage market, the sector is actually in a "precarious" state as it faces the risk of a downside move.

"The downside can come in one of three forms," said Andrew Davidson, president of the Andrew Davidson & Co., citing a slowing housing market, a rise in interest rates and widening spreads.

A slowing housing market could result in reduced prepayment speeds as well as an increased default risk. Davidson said that while the rise in default risk does not impact the Agency market, it would affect some of the other mortgage products in which there may be increasing delinquencies and losses.

He explained that though slowing prepayments is not necessarily a bad thing for premium MBS, in a rising interest rate environment, premium coupons could become discounts and slower prepayments would accelerate the extension risk on those products.

Davidson also mentioned that if interest rates rise - particularly in the short end of the yield curve - the result would be less income for spread investors and price declines, which would lower total returns.

The third risk is spread widening. Mortgage spreads, Davidson said, are being supported by aggressive buying by those who needed to buy duration, such as Fannie Mae, as their portfolios shortened due to accelerated prepayments.

And with the current coupon compression in the mortgage market, this risk is exacerbated. "This means that everyone is facing the same profile on their mortgage portfolio," said Davidson. "If rates rise and duration extends for one investor, it would be extending for many others as well because everyone is investing in a narrow band of coupons. Mortgage players would have to act in concert with one another."

He added that it is not certain whether this situation would occur, "but it is certainly a plausible scenario that we think investors should start looking at this pretty carefully to see how they are positioning themselves in the event that it does occur."

There is some reason to believe that all these types of downsides could come together and create a "perfect storm" in the mortgage market.

Davidson explained how these risks could be linked. Higher interest rates, he said, would likely put pressure on the housing market as affordability dips. And with higher rates, stagnant incomes would not be able to support the level of housing consumption. Further, higher rates and a slowing housing market could jointly cause reduced prepayments as well as well as greater extension risk. The increased duration, reduced carry and greater credit risk would result in selling and widening spreads as buysiders seek to rebalance their portfolios away from the mortgage sector.

So what is the smart move at this juncture? "I don't think that you could really give up carry," said Davidson. "What people need to do is figure out what their trigger points are so that they are prepared when the market starts moving and know when the carry stops working for them versus the potential price declines." Investors need to determine the level of flattening of the yield curve that starts cutting into their carry significantly enough that it's not worth bearing the risk. If investors cannot get comfortable with those exit points, they should start looking to caps or some other hedging protection that may help them through that adverse scenario, Davidson said.

The biggest risk is extension

Extension risk, as opposed to contraction risk, is the bigger issue for the mortgage market at this point, said analysts from UBS Warburg in a recent report. However, UBS points out that most of the trades that could deliver protection from extension risk would also negatively affect carry. This means that if the market does not trade off, researchers stated that buysiders would be underperforming the mortgage index.

The researchers warned that "investors can ill afford to ignore the extension risk issue. This situation arises because the reshaping of the mortgage market and the greater concentration in lower coupon mortgages have turned extension risk into a pressing problem."

They added that since bank activity is bound to stop when rates rise, this would only further the negative price action.

To solve this conundrum of positive carry trades, and take into account extension risk, UBS analysts suggest overweighting mortgages as a sector but focusing on those with shorter duration. They also recommend underweighting - but having a longer duration - in Treasury securities. This would counteract the loss in carry incurred from buying mortgages with less extension risk. The loss could also be offset by extending duration in the corporate market, taking advantage of anticipated spread tightening in the sector.

This is not to say that investors should drop the carry trade. Buysiders should look at securities that dollar roll well and they should go into non-generic mortgage product that carry better than generic mortgages. This would include specified pool mortgages and CMO product that are backed by coupons now unusable for CMO transactions.

Other analysts said that with the mortgage index at a very high dollar price, in all likelihood duration can only get longer. This is why extension is now the biggest risk in the mortgage market. However, certain factors are still working in the sector's favor. Extension risk can only happen if the market sells off by at least 100 basis points. Moreover, it is only going to be in the initial leg of a sell-off that mortgages would be hurt. Once it settles at those rate levels, mortgages would do well again.

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