Although it's not going to be all smooth sailing in MBS land next year, things are expected to look up for the sector in the second half of 2006.

Countrywide Securities Senior Strategist Bill Berliner said that he is short-term neutral to bearish on MBS with the threat of an inverted yield curve in the first six months of 2006. He explained that under a flat or inverted yield curve scenario, increased funding costs push carry into negative territory, while OAS-based valuations also suffer. However, he is optimistic that after the first half, things should begin to look up for the sector especially with expected demand from non-traditional sources like Asia.

Berliner said that the higher coupons are poised to suffer the most from an inverted yield curve and rising interest rates. "In general, the higher coupons will suffer the most from rising mortgage rates because they have not fully extended and have not reached their prepayment speed targets," said Berliner. The greatest duration extension occurs when speeds slow from around 25% to 30% CPR to the high teens, which 6s are in the process of doing. Meanwhile, 5s and 5.5s are currently prepaying at the low-to-mid teen CPR area, thus would not be seeing as much duration extension. "Although higher coupons may carry well currently, they are not going to look good from a total return perspective, especially as they move through parity in a selloff," Berliner said.

Though Berliner expects home price growth to slow in the next year, he does not expect turnover speeds to decelerate dramatically. "It would take a major slowdown in residential real estate activity for this to happen," said Berliner. However, he said that slowing home appreciation will dampen cashout refinancing activity, especially for newer loans in areas where real estate appreciation has been slower than the national averages. "It may look like a slowdown in turnover, but in reality it's a different phenomenon," he said.

On the buyside front, investors will be closely monitoring economic events to see where the market is headed, while still keeping their eye on the changes in Federal Reserve management. Bill Chepolis, a managing director in the fixed-income group at Deutsche Asset Management, said that market participants are still "obsessively focused" on the Fed, particularly with Ben Bernake's replacing Alan Greenspan as Fed Chairman. However, Chepolis believes this transition is going to be a non-event especially with the new Chairman expected to carry out Greenspan's policies and the FOMC statement last week about removing its accommodative stance. In fact, next year, Chepolis expects people to focus more on the economy, particularly on hurricane-damaged states like Louisiana. The revival expected in these states should spur economic expansion. "That's what people are watching out for, how things are rolling out there," said Chepolis.

Chepolis said that he is worried about the consumer. Although rising fuel costs didn't seem to have much on of an impact, he is concerned that heating costs, what he calls "the second leg," is the factor that "would really bite in." Aside from the cost of gas, other underlying economic events that might influence the market is a potential 4.50% yield based on where the Fed Funds rate and the 10-year Treasury are as well as the dollar's expected weakening next year, with an eye towards how this would affect Asian buying.

In terms of mortgages, the lack of buyers would still present a problem, especially with spreads so tight. Chepolis does not anticipate the GSEs to revert back to their former 25% growth rate but he anticipates them increasing their mortgage exposure by 5% to 10%, unless spreads widen dramatically. Banks are also looking for investments that would not dilute their ratios. But with Fed Funds potentially at 4.50% or higher, Chepolis said that it might not make sense for banks to hold mortgages at these levels.

"Everybody is conscious about how tight spreads are," Chepolis said, with many participants currently "grabbing at anything to start a trade." He added that with "so many trying to eek the next thirty second off of a trade, it's not necessarily following any sort of trend."

In terms of his firm, Chepolis said that for the past quarter, they have been cautious on spreads for the most part and favor higher coupons for their shorter duration and slower prepayments. In the third quarter, Deutsche looked favorably on 15 years, but they have since reduced their exposure. Chepolis likes the carry found in 30 years, as well as holding a decent size position in Treasurys. Coming into the new-year, Chepolis says an important factor to look at would be turnover, specifically in the 5% and 5.50% coupons where speeds in the 2003 and new vintages are converging. The differences are not as payups would suggest," Chepolis said. In 2006, it remains to be seen whether the turnover story would result in any price adjustment.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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