With declining prepayment expectations due to the recent back-up in 30-year mortgage rates, concerns about the lengthening duration of mortgage securities are beginning to hit the market.

Analysts from Lehman Brothers said that since the end of October the total extension of duration in the mortgage market is approximately 450 billion in 10-year equivalents.

Though the numbers look alarming and are currently causing concern among MBS market players, experts say that it may not actually be that bad.

For one thing, people who buy MBS are compensated for taking on this kind of risk. Aside from this, those who are using a mortgage index as a benchmark should not really be affected, because although their portfolio has lengthened, so has their benchmark.

According to Srinivas Modukuri, senior mortgage strategist from Lehman Brothers, extension risk is a bigger issue for those on the asset and liability side. People on this side of the fence may need to come in and rebalance their mortgage portfolios which have extended.

"The duration of mortgages does move around, we have seen this in the past," said Modukuri. "The only issue would be how much of a rebalancing do the asset liability people need to do, and how is that going to affect everybody else?"

Other analysts said that mortgage servicers, for instance, have had to hedge their portfolios against the loss of revenue due to the pick-up in prepayments. With the current refinancing wave, the servicers' portfolios have been turning over so rapidly that there has been an erosion in their ability to make money.

Though the increase in rates will slow portfolio turnover and improve the servicers' ability to make money, it might also cause servicers to be significantly under-hedged. Instead of hedging to a 2.2-year empirical duration, for instance, now they would have to hedge to a 4.4-year empirical duration.

Modukuri said it is going to be pure speculation to try and guess how much has been done and how much still needs to be done in terms of portfolio rebalancing. But he stated that one thing to keep in mind is that before the mortgage rates sold off about 70 basis points in November, during the month of October the market also rallied about 35 to 40 basis points.

"I would say that to the extent that there was not a lot of rebalancing done in October, the pain of duration extension has been mitigated this time too," said Modukuri.

Extension risk and

prepayments

Modukuri said that the component of extension risk that market players should be more worried about is coming from the prepayment side. With the possibility of a slowing housing market, prepayment expectations will decline, causing extension risk.

Though the last few years have seen very high housing turnover rates because of a strong housing market, the sector is showing signs of weakness due to the recessionary economy. And if the mid-1990s turnover fallout is used as a benchmark, turnover volume can decline by a significant amount. This kind of extension risk could have a very big impact on mortgage investors.

However, since mortgage rates are still at historically low levels many mortgage players are not unduly concerned about the extension risk that could be caused by a housing turnover plunge.

But Modukuri warns that "the risk from extension is not so much from just duration of extending but it is more from a potential big decline of turnover rates."

Analysts said although the recent housing numbers - e.g., housing sales and the purchase index - do not look that bad, people have to keep in mind that mortgage rates are currently at very low levels. If one looks at year-over-year mortgage rates, they are about 100 basis points lower.

The fact that rates have gone down that low would mean that if everything is fine with the housing sector, both the purchase index and housing sales should be up year-over-year, but they are not. The lower rates are masking some of the weakness in housing turnover.

Meanwhile, Greenwich Capital analysts said that if the demand for housing has been really sensitive to mortgage rates and has been held up by the plunging rates this year, then housing sales may be on the brink of a steep decline since 30-year mortgage rates have backed-up.

They added that it is more likely that as long as rates remain historically low, home sales can survive the next several months with only limited declines, especially if consumer confidence comes back.

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