In a report released this morning, Merrill Lynch analysts talked about a proposal that the market allow certain re- REMIC classes that are economically the same as pass-throughs to basically be remade into passthroughs.

According to the research, if this were the case, the recombining CMOs could give a considerable lift to the CMO market, specifically to those classes that are the most likely beneficiaries.

In the current scenario, Merrill analysts said that non-deliverable agency MBS — CMOs, Hybrids, 10/20 pools, etc — trade at a considerable discount to TBA as a result of lower liquidity, higher haircuts, and increased pressure on balance sheet. 

This clearly contrasts with those mortgage-backeds that are deliverable into TBAs, such as most specified pools and Trust IO/POs.

Merrill analysts said that, unfortunately, hybrids and 10/20 pools can never be eligible for delivery into 30-year TBA as the cash flows of these bonds vary from that of 30-year amortizing mortgages.

But, some CMOs could actually exhibit the exact same cash flows of a 30-year amortizing mortgage pool. For instance, a front sequential and back sequential could be recombined into a new CMO that has the same cash flows as a passthrough.

Although at present this type of CMO is not TBA deliverable, a recent proposal circulating in the market implies that a mechanism be developed to allow these recombined securities to be recast into pool form that would be TBA deliverable.

If this proposal were to come to fruition, the ruling could reestablish a price floor for many secondary CMOs. This would probably result in a considerable rise in CMO
liquidity as well as a narrowing of the CMO/passthrough basis.

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