Some Wall Street executives see signs that the market for debt securities is cooling in the wake of recent turmoil.
The question is whether the residential mortgage-backed securities market will falter too.
There has been "a change in the credit cycle," said Craig S. Phillips, managing director at Morgan Stanley & Co. "There's just tremendous dislocation in the fixed-income markets generally, which has hurt all securities."
"Spreads have widened already," said Henry Willmore, senior economist for Barclays Capital in New York. "It's all a reflection of the view that the outlook is more uncertain."
Normally investors would rush to high-grade, fixed-income securities as they flee equities. But to counter deep losses in emerging markets and stock markets, some holders of mortgage- and asset-backed securities are selling them to raise cash, Mr. Phillips said.
The low interest rate environment and rising prepayments also threaten to dampen investor interest, observers said.
Mortgage lenders would feel the effects if investors were to spurn mortgage-backed securities in the months ahead. They depend on an active secondary market to replenish their capital for lending.
Investors may be waiting for the market to "settle down and get a sense of relative value back again," Mr. Phillips said.
Banks themselves, which are typically both investors in mortgage securities and suppliers of mortgages to the secondary market, are part of the flight to quality. They have stepped up their investments in Treasuries despite relatively low yields, because of their rising concerns about risk, Mr. Willmore said.
One sign of the growing anxiety over mortgage-backeds is that risk managers on Wall Street have begun changing their hedging strategies. Instead of hedging with Treasuries, as they were doing recently, they are asking their trading desks to use more swaps. These off-balance-sheet transactions between dealers and investors, or dealers and other dealers, provide more protection when markets turn volatile, analysts said.
To be sure, some on Wall Street see little risk that the market turmoil will take a big toll on the residential mortgage-backed market.
"Mortgage credit is in good shape right now," said Dale Westhoff, senior managing director for mortgage research at Bear Stearns. The outlook is that it will improve, he said, with low mortgage rates and home prices generally increasing everywhere across the nation, including California.
Mortgage rates have fallen below 7% to 30-year lows, and close to 80% of the mortgage market is now exposed to the "best-ever refinancing opportunity," he said.
Default rates on first mortgages in the residential sector are falling, and spreads on mortgages versus Treasuries are the widest they have been in six years, Mr. Westhoff added.
Still, he acknowledged, though spreads are high, the prepayment risk is also high.
Certainly, the mortgage market is exhibiting signs of anxiety. When mortgage investors tried to exit swiftly in last week's turmoil, would-be sellers outnumbered buyers so much that it led to "no natural bid" for mortgages, one trader said. "There was a complete lack of sponsorship in the mortgage market."
The trader said the fact that borrowing rates have not dropped markedly since last Monday's rout settled investors down somewhat.
While the market sorts itself out, Mr. Westhoff of Bear Stearns advocates selective investment and buying securities with low risk of prepayment.
Investors should be looking to make a "buy-and-hold-type decision," he said, because they might not be able to liquidate at levels they want to.
Mortgages and most other spread products "have not participated in the Treasury rally by any stretch of the imagination," said Peter L. Struck, first vice president and manager of the Treasury division for Washington Mutual in Seattle.
But "now that spreads have widened out, investors are beginning to tiptoe back," he said.
The low mortgage rates may bolster the housing market, but uncertainty in equity markets and mutual funds may mean that there will be "less demand for homes, given that borrowers are more uncertain about the future," Mr. Westhoff of Bear Stearns noted.
The secondary market is "on the cusp" of experiencing a good flow of refinancings if there is another one-point rally in mortgages, said Christopher D. Goode, senior vice president, director of secondary marketing for Home Savings of America, Irwindale, Calif.
But more people are now "on the fence"-putting in applications for mortgages and waiting-because Treasuries are rallying but mortgages are staying in the same position, he said.