Wall Street Watch: Wider Spreads Draw Investors Back to Mortgages

Investors have been jumping back into the mortgage securities market despite continued concerns about prepayment risk.

Dale Westhoff, senior managing director for mortgage research at Bear, Stearns & Co., attributed the revived interest to the widening of spreads on securities in all asset classes.

Spreads-the gap between the yields on Treasury securities and asset- backeds-are much wider than in high-prepayment environments in 1993, 1996, and at the beginning of 1998, he said.

The wider spreads partially reflect a flight to quality in response to the global credit crisis, Mr. Westhoff said. As spreads have widened, he said, the environment for mortgages has improved, thanks to higher loan rates and the subsequent reduction in refinancing.

The investment environment is "surprisingly healthy" for all spread products, said Craig S. Phillips, managing director at Morgan Stanley & Co.

But the return to the mortgage-backed securities market "is very cautionary in tone," said Peter L. Struck, first vice president and manager of the Treasury division at Washington Mutual Inc., Seattle.

As yearend approaches, investors may start to focus again on concerns about liquidity, he said. Also, further moves by the Federal Reserve to lower short-term interest rates might lead to a drop in longer-term rates and another "avalanche" of refinancings, he added.

"Things look fairly enticing right now," Mr. Struck said, but he warned of the "potential for a lot of volatility."

When mortgage rates fall, borrowers who refinance prepay. Investors then get their cash back early, so they must re-invest it at lower rates. This cuts their returns and makes them leery of going back into the water.

Investors face yearend constraints that preclude them from making big bets in any market, but Wall Street is looking forward to the first quarter, when these barriers will be gone and returned cash from prepayments will give investors significant capital to reinvest.

Mr. Phillips noted that spreads often widen in December but did so two months early this year.

Now, as investors come back into the market, they are sorting out which bonds have good value, he said. But, he added, investors have returned with less appetite for risk, and this has resulted in a "fairly significant loss of liquidity."

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