Mortgage product was smashed during the last couple of weeks as the rally in Treasurys caused the worst week for the mortgage market since the bond market crisis in 1998. Spreads widened by more than 30 basis points, but seemed to have come back quite a bit by the end of the week, sources said.

In a single week, from January 27 to February 3, the 30-year interpolated current coupon MBS spread widened from 128 basis points to 159 basis points over the 10-year Treasury yield, according to Nomura Securities.

"Having experienced three episodes of MBS market turmoil in a year and a half, MBS investors and traders have to ask themselves if the Treasury market is still a useful benchmark and hedging vehicle for mortgage-backed securities," said Art Frank, head of MBS research at Nomura.

Fannie Mae 8% bonds fell 9/32 to 99 12/32, their yield rising six basis points to 8.16%, and 6% coupon mortgages declined 17/32.

The 10-year Treasury, a benchmark for mortgage rates, tumbled 26/32 to 98 24/32, its yield rising 13 basis points to 6.67%. The higher yields and large interest payments mortgages offer can protect investors from some losses if rates rise and prices of the securities fall.

According to Frank, two considerations led some large banks, money managers, dealers and trading accounts to simultaneously sell spread product and buy intermediate and long Treasurys over the past week, driving spreads wider. The first was investor anticipation of the Treasury buyback program.

The second was the extremely special levels at which on-the-run Treasurys were trading in the repurchase market, with funding for the 10-year on-the-run issue ranging from 0.5% to 1.0% for the past week.

Later in the week, the five-year funding level fell below 1% as well. For investors, the Treasury's effect seems to have created many opportunities, as many investors wait for spreads to increase again, which would encourage some buying action.

Affect on CMBS

Of relevance, asset-backed analysts believe that the effect of last week's Treasury buy-back announcement and Treasury volatility has been that trading activity for both ABS and CMBS ended up being quite muted in recent days as investors chose to wait out the frantic developments in the Treasury market.

According to a report put out by Deutsche Bank Alex. Brown, between the volatility and the inversion of the Treasury curve, spreads to Treasuries have widened significantly.

Over the past two week, CMBS 10-year AAA tier 2 spreads jumped from 109 basis points to 132 basis points, while fixed-rate spreads in the ABS market gapped out from 6 to as much as 31 basis points depending on product and maturity.

"With the latest burst of volatility, we are again seeing a steeper credit curve (in addition to wider spreads) across the swaps, CMBS and ABS markets," said Nichol Bakalar, an analyst at Deutsche Bank. "Many dealers hedge ABS inventories with swaps during volatile periods, and with light trading activity, they tend to mark their positions in line with changes in swaps unless there is reason to believe their postions have out- or under-performed swaps."

In the view of Deutsche Bank, it is just a matter of time before credit curves flatten somewhat. Additionally, change in the CMBS market will occur "in line with a credit curve flattening in the swaps market." This flattening could occur either because the Treasury curve returns to a more normal shape, or as a result of the spread sectors adjusting to a new Treasury market.

"The major caveat is if the markets become convinced in the near future that the economy is headed for a slowdown or recession, in which case credit curves could steepen further," Bakalar says in her report.

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