Anticipating Tuesday's easing by the Federal Reserve Board, mortgage strategists and prepayment analysts on Wall Street had differing views of whether to buy or sell securities backed by residential mortgages.
Morgan Stanley distributed an e-mail note to investors on the "top 10 reasons" to sell them. Other firms, including Donaldson, Lufkin & Jenrette and Prudential Securities, were more upbeat about them.
Morgan Stanley downgraded residential mortgages from "overweight" to "neutral," said Alec Crawford, vice president for mortgage strategy. He said the company recommended that investors shift into AAA-rated securities backed by commercial mortgages and into home equity paper, which is now cheap.
Morgan Stanley had correctly guessed how much the Fed would cut-25 basis points. The cut will be bad in the short term for mortgage securities, as Treasuries rally, the company said. But it will be good in the long term, as financing costs drop.
Another reason for selling now is that mortgages have performed strongly over the past week and Morgan Stanley's models show they have reached "fair value" when compared to agency spreads and the level of the 10-year Treasury, the note said.
"If the market rallies, mortgages are very likely to underperform their Treasury hedges," Mr. Crawford said. "The performance of mortgages is tied, at least over the short run, with what direction Treasuries go in."
Other reasons to sell, the firm said, include rising short-term volatility that could lead to longer-term volatility, and the extremely high level of mortgage issuance in 1998. Callable agency spreads are also at their widest levels of the decade, and more mortgage investors may sell if they experience further hits to their portfolios.
Donaldson Lufkin is taking a more positive view on mortgages. "Virtually every mortgage is refinanceable right now," said Bruce R. Alpern, senior vice president, head of mortgage and asset-backed research. A rate cut would make little difference, he said.
The firm thinks the steepening yield curve will attract investors, Mr. Alpern added. There are still investors eager to purchase mortgage-backed securities, he said.
Mortgages have been "cheapening up pretty dramatically in the last few weeks as the market has rallied," he said. They have not been this cheap since the late 1980s, he said.
Depository institutions increased their non-Treasury holdings during the last few months to pick up additional spread and in anticipation of the Fed easing, Mr. Alpern said. DLJ estimates that these holdings are primarily investments in mortgage-backed securities, he said. These non-Treasury holdings are expected to increase if and when the Fed eases, he added.
Fed easing will probably make the yield curve steeper, said Inna Koren, first vice president for fixed-income research at Prudential Securities. "We think steepening is positive to all spread products, including mortgages.
Mortgage securities offer "great relative value," she said.
Prudential is advising investors to buy mortgage-backeds, but Ms. Koren cautioned that there is a lot of prepayment uncertainty. But though spreads will be volatile in the short term, she said, a consenus is building among investors on Wall Street that mortgage-backed securities will do relatively well over the long term.
