With the refi wave in full throttle and a steepening yield curve fueling bank demand, CMO issuance is skyrocketing, sources said.

"If you look at gross CMO issuance and you compare it to gross changes in bank MBS holdings, you will see that the two are historically very closely correlated," said Michael McCarthy, an analyst at Merrill Lynch. "What it boils down to is if the banks are in buying [mode] then CMOs would be in demand."

A combination of factors is contributing to the rise in agency CMO issuance. In addition to prepayment speed acceleration, the GSEs have been calling up their bonds to take advantage of lower interest rates, and deposit rates have increased 15% to 17%, leaving the banks with excess cash on their hands.

Some sources also indicate that the increase in agency CMO volume is also driven, to a degree, by Freddie Mac's participation. The agency has taken bonds retained in its own portfolio and sold them off as PAC-2 bonds while tranching up the rest into CMOs.

Because of the slowing economy, there has been limited profitable opportunities for banks to extend traditional credit, so MBS looks very attractive. As one MBS analyst noted, "Banks don't feel comfortable making loans to some corporation that's going belly-up."

The banks' cost of funds is closely related to short term Libor - one-month Libor or three-month Libor - which follow Fed rates very closely.

"Back in the third quarter, when the yield curve was flat, the spread between 5s and 6.5s sequentials and one-month Libor was about 20 basis points and that relationship has changed now to about 200 basis points," said Merrill's McCarthy. "So it's become far more profitable for banks to take the cash deposits and just buy mortgages."

Moreover, there has been reasonable demand from the agencies to buy MBS for their own portfolios. This is because the difference in spread between mortgage spreads and the spread offered on Fannie/Freddie debentures has recently reached a two-year wide, so it has made it profitable for Fannie/Freddie to issue debt and with that money use it to buy MBS.

Foreign investors

on the horizon

Another future growth opportunity for CMOs is the increasing interest of non-U.S. investors who used to manage their funds based on an Index that is comprised mostly of G7 Treasurys and government securities. But because the U.S. and the European community have exercised fiscal balance, the amount of Euro and U.S. dollar government securities have gone down and those who still follow the old Index are left investing in lower-yielding Japanese securities.

Therefore, investors have started to look into International Aggregate Indices, of which U.S. mortgages comprise 16%. This would be a large growth area because the newly-industrialized countries alone, for instance, have foreign currency reserves that range from $80 billion to $120 billion each.

"A lot of the non-U.S. investors are on the research stage to learn what the U.S. mortgage market is about," said Jeffrey Ho, a director in the mortgage strategy group of UBS Warburg. "Though it won't happen overnight, people are going to be shifting to Indices where US mortgages comprise 16%."

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