In CMO land, analysts anticipate that although originations in the sector will dip in 2005, it would remain robust relative to the issuance in the mortgage market as a whole, which is expected to decline significantly.
"The spread that CMOs currently offer are still attractive even with a flatter curve," said Victoria Averbukh, an MBS analyst from Deutsche Bank Securities. Averbukh added that CMOs offer a wide range of short-duration products that appeal to many investors in a bearish interest-rate market.
Averbukh is expecting more relative value players and more active secondary trading in CMOs next year compared to 2004. Although less buying in the sector is predicted going forward, a more diverse mix of investors is expected to enter, including both foreign and real money buyers.
She added that there would be more interest in leveraged products, including structured and inverse IOs. "We think volatility is likely to remain low in 2005," said Averbukh. "Spreads are getting tighter and, as the curve flattens, the carry is not as attractive, so investors have to increase returns in some other way and leverage is a one way to do this." However, she cautioned, that such strategies might become damaging if the current interest rate environment changes dramatically.
Averbukh also commented on the current innovations in the mortgage market, particularly in the hybrid sector, such as IO hybrids. She noted that the investor base is growing for the hybrid product. Traditionally, only banks and REITs bought this collateral type for the carry it provides, but relative value and foreign investors are now interested in the product.
Issuance in the IO hybrid sector, in particular, is expected to remain strong in Agency, Jumbo and Alt-A collateral, at least in the near term, Averbukh said. "Its not mortgage rates driving issuance, but the monthly payments that borrowers have to make," she said. By not paying the principal on the loan, Averbukh said, homeowners are saving as much as 150 basis points a month on their mortgage payments during the IO-only period of their loans. The IO hybrid is an attractive option for those who have short-term horizons, such as borrowers who are confident in their ability to pay their mortgage in full or are planning to move or upgrade their house before the reset period, but they can be a dangerous product for borrowers who do not realize by how much their monthly payments will increase after the interest-only period is over, Averbukh added. She doesn't view the Jumbo or Agency markets to be at a significant risk because of the proliferation of hybrid IOs. However, these product innovations might add to the "subprimish" quality of the Alt-A sector because of the more aggressive underwriting, Averbukh said. Among the main risks to the Jumbo markets, she cites a growing potential for a California housing market downturn.
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