Uncertainty has lingered this week for investors in mortgage-backed securities in the aftermath of Federal Reserve Chairman Alan Greenspan's reference to deflation at the American Economics Association in Chicago Saturday.
Mr. Greenspan's remarks shook up Wall Street, catching people off guard and sending government securities prices soaring. Some traders thought the market got carried away.
"People who have profits in their bond paper are taking the paper out," said one trader.
Investors are trying to figure out where to go from here because "what used to be benchmarks don't seem to work anymore," he noted.
"I think there's a lot of uncertainty from investors about what to do here," said Inna Koren, first vice president for fixed-income research at Prudential Securities, New York. "We're in a new environment which we have never experienced before."
Because of this uncertainty, numerous portfolio managers investing in mortgage-backed securities declined to be interviewed.
"I think mortgages are likely to underperform here given what's happened," said Dale Westhoff, senior managing director for mortgage research at Bear, Stearns & Co., New York. Continued net selling of mortgages and an investor preference for lower coupons with more prepayment protection are likely, he said, as investors adjust their positions to reduce prepayment risk.
With the rally on Monday, the 7.5% coupon, which passes on a 7.5% yield to investors, is 25% of the fixed-rate mortgage market and is now fully refinanceable, Mr. Westhoff said. Because a lot of investors have exposure to that coupon, they are experiencing prepayment pressure, he said.
Rates are also at four-year lows. "Now we're only 10 basis points away from the 1993 low in mortgage rates, which is very significant I think for the mortgage market," he added.
"That suggests that we're exposing all borrowers who took out mortgages after 1993 to their best-ever opportunity to refinance," Mr. Westhoff said. Bear Stearns increased its prepayment forecast Monday.
"You're likely to see a lot of cash flows going out of mortgages and into asset-backed" securities, which have less prepayment risk, or into Treasuries, Mr. Westhoff said. "Even if an investor decides to do nothing, he's going to see a lot of reinvestment cash flows."
Bear Stearns is forecasting prepayments of more than $20 billion a month coming back to investors for the first quarter of 1998.
"We still see money coming into the mortgage market, but people are focused on the lower coupons," said Arthur Q. Frank, senior vice president for mortgage research at HSBC Securities Inc. Conventional 30-year mortgages issued at 6%, the lowest coupon with the most prepayment security, experienced "significant investor buying" this week, Mr. Frank said.
"What has been a very, very quiet coupon has new activity and investors going down in coupon because of prepayment fears," he said. With the 10- year Treasury note falling below 5.50%, "we're seeing some production in 30-year 6's for the first time in two years."
While investors are likely to reinvest in Treasuries or asset-backeds given the prepayment risks associated with mortgage-backed securities, it does not necessarily give Wall Street or investors a leg up in the market.
Dealers also have positions that they are trying to hedge, and they can suffer as much as investors. But more overall trading activity on Wall Street is likely because investors may make more reallocation decisions in this environment.