In nearing the tail end of a period of volatility, it becomes clear that this cycle was not nearly as volatile as the comparable cycle in 1993, said MBS analysts on the Wall Street Update panel at the Mortgage Bankers Association's (MBA) conference last week.

Industry participants now face a period of incremental market movements, as opposed to the rather roller coaster-like ride seen last year.

There are several reasons why the market is looking, relatively, more stable at the moment. Dale Westhoff, senior managing director at Bear Stearns, noted that the refinancing incentive at the peak of last year's wave was 150 basis points, compared to today where it's closer to 20 basis points. Also, 97% of the mortgage market (or $2.7 trillion) was refinanceable in June last year, compared to only 33% (or $987 billion) currently. Aside from these, the duration of the market was extremely compressed (0.88 years) during the same period. This is compared to 3.5 years currently. Thus duration selling, if and when it occurs, will not be as pronounced.

Furthermore, even with the recent spike in mortgage applications, because of excess capacity the resulting refi wave will be rapid, and the market should stabilize by mid-summer, Westhoff said.

Market fundamentals are also quite positive. With the sell-off, the market has become less negatively convex. And with the decreasing origination volumes, excess capacity exists in the mortgage pipeline. This decrease has caused shorter lags between applications and closings and has resulted in a more stable primary-to-secondary spread. Mortgage supply has also decreased over 50%.

According to Westhoff, the next prepayment threshold will be a 5.40% mortgage rate (expected to trigger a response in 5.5s) - which corresponds to a 3.70% 10-year Treasury - and then followed by 5.25% (3.50% 10-year Treasury). Mortgage rates would also have to fall through 5.0% (3.25% 10-year) to replicate the refinancing exposure in the early part of last June.

The real risk today is curve flattening, says Westhoff, and erosion of the carry trade, and investors increasingly are focused on hedging the potential for this event. Prepayment risk is now focused on the lower coupons, such as 5s and 5.5s, as opposed to coupons above 6%. The 2003 vintage coupon stack is most exposed to prepayment.

The market is now transitioning into a purchase environment, Westhoff noted. This brings extension risk into the equation as purchases have more intrinsic extension risk compared to refinancing loans. Borrowers in new homes have neither the tenure nor the equity in their properties.

There seems to be increasing extension risk in 30-year collateral, Westhoff stated, as the more mobile 30-year borrowers, prompted by the historically low mortgage rates, are now moving into hybrids. Adding to this trend were Federal Reserve Chairman Alan Greenspan's recent comments highlighting hybrid mortgages as an attractive alternative to traditional 30-year financing.

Hybrids are a good product for extension protection, Westhoff noted. The hybrid sector is currently attractive versus other comparable duration mortgage products, he added.

Convexity hedging

Aside from Westhoff's presentation, Laurie Goodman, senior managing director of the mortgage strategy group at UBS, also addressed current trends in the mortgage market, paying particular attention to the role of convexity hedging. This phenomenon has played a significant role in the market in the past few years, she said. However, it will become less important as rates rise. Goodman emphasized the importance of understanding the dynamics of convexity hedging. Convexity hedging amplifies market moves but does not cause them, she said.

Convexity hedging has become more prominent as a result of several factors: the growth of the mortgage market relative to other fixed-income markets, greater originator concentration, the added efficiency in the refi process, and the shift to mortgage investors who hedge convexity, including Fannie Mae and Freddie Mac, relative to those who don't.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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