Investor demand for collateralized mortgage obligations is on the rise, traders say.
Issuance of the packages of the mortgage securities - also called real estate mortgage investment conduits-has been growing since January.
Issuance this month is on a pace to exceed January's healthy $24.8 billion of securities backed by Fannie Mae and Freddie Mac loans, said Brian Lancaster, managing director at Bear, Stearns & Co. He attributed the surge mainly to a reduction in investors' liquidity concerns.
Citing statistics from Bloomberg News, he said issuance of the securities packages so far this year stands at $59.1 billion, including whole loans and agency CMOs.
"Right now, there's a lot of demand for shorter bonds," Mr. Lancaster said. "The whole market is a more bearish environment."
He said the increased buying of CMOs is due to a confluence of factors.
"As liquidity becomes a lesser concern, people begin to go from more liquid to less liquid markets," Mr. Lancaster said.
Extension risk is another factor. With low mortgage rates, inestors have been focused on call risk-the fear that bonds will be called away because of prepayments. As rates rise, extension risk-the risk that loans do not prepay-becomes more of a worry.
What's more, Treasury rates have been rising in the last few weeks, pulling up mortgage rates, Mr. Lancaster noted.
On Friday, the zero-point effective mortgage rate was7.15%. It had been hovering between 6.90% and 7%, he noted. Overall in the market, there appears to be more extension risk than call risk, Mr. Lancaster said.
To respond, investors-primarily banks and financial institutions-are buying more CMOs because they are less liquid than pass-through securities. Investors are also buying planned amortization class securities, or PACs, which give more protection against extension risk than call risk, Mr. Lancaster said.
Banks have been big buyers of the shorter-duration bonds, especially in the past month, as yields on Treasuries have risen: by 34 basis points on two-year bonds and 40 basis points on five-year bonds. Mr. Lancaster said the yield curve's slight steepening was not the major factor in increased CMO issuance. But some analysts said it could put pressure on companies like Fannie Mae, Freddie Mac, and large commercial banks and thrifts, who need top-line asset growth.
Top-line growth is achieved by buying mortgage-backed securities or other structured paper, rather than originating loans.
"Wall Street is a bigger owner and buyer of spread products in general when the yield curve is steep," said Alec Crawford, a vice president in mortgage strategy at Morgan Stanley Dean Witter & Co.
Spreads between the 30-year mortgage and 10-year Treasury bond will normalize as the year progresses, said David Lereah, chief economist of the Mortgage Bankers Association.
Spreads are "going to be narrowing throughout the year," he predicted, noting that markets are returning to a more "normal" environment. "We think refinancing activity will slow somewhat throughout the year as well," he added.
Mr. Lereah said that if the world economy improves there will be less investor flight to quality. This would lead to "bigger increases in long- term rates than short-term rates, which will give you a steepening yield curve," he said.
