Investors buckled their safety belts at the beginning of 1998 as the mortgage market raced ahead to record levels - and they are still feeling the wind in their faces.

In January, the seasonally adjusted Mortgage Bankers Association refinancing index hit its highest point ever and homeownership during the first quarter was measured at 65.9%.

Fast prepayments have dominated the pricing in the mortgage market in 1998. This year, spreads between mortgage paper and Treasuries have been driven by prepayment volatility, while in 1997 they were affected by declining implied volatility in the marketplace, said Inna Koren, first vice president at Prudential Securities.

"It is definitely a hot market right now for mortgages," said William J. Denton, vice president for secondary marketing at PNC Mortgage.

"All types of mortgage securities right now are in demand," he said. "The main reason is that Treasury debt is drying up." Mortgages also offer better yields and less credit risk than other alternatives, he said.

Mortgages have been bolstered by strong demand from agencies, by the large amounts of cash investors have to reinvest as a result of increased prepayments, and strong demand for collateralized mortgage obligations (CMOs), said Ms. Koren.

In 1998, CMO issuance has picked up dramatically with close to $60 billion issued so far, she said. Increased prepayment risk in the mortgage market has increased demand for call protection in the Remic market. As a result, almost 75% of all Remic deals in 1998 used PAC/companion structure. PAC bonds offer investors greater stability in average life. They provide call protection, an attractive characteristic for investors.

Investors in mortgages include Fannie Mae and Freddie Mac, commercial banks, insurance companies, hedge funds, and managers of fixed-income portfolio. All investors examine the geometry of the market - the shapes of the yield curve, the line of interest rates, and the way the arrow points for Treasuries - to make their investment decisions. But they all have different institutional preferences and constraints governing their buying behavior.

Fannie Mae and Freddie Mac are some of the largest investors in mortgage-backed securities. Agencies buy mortgages when the spread between agency debt and mortgages is widening. And agencies usually stop buying mortgages when that spread collapses.

"Recently, that spread has actually narrowed from the widest levels, but we're still seeing agencies continuing to purchase mortgages in big bulk," she said. Fannie and Freddie are buying with the proceeds of the enormous debt offerings they floated in the first quarter, when rates were much lower, and not as a result of new issuance of mortgages, said Ms. Koren. Now Fannie and Freddie are buying mortgages at higher yield levels because Treasury yields have risen, she said.

The two agencies hold more than $512 billion in their portfolios, representing about 12% of the mortgage market, said Ms. Koren. At the end of March, Fannie had $137.5 billion of mortgage-backed securities in portfolio, not including non-Fannie Mae mortgage-backeds.

Freddie Mac's retained portfolio has a value of $186 billion, with $120 billion of them Freddie Mac securities. The majority of the rest of the portfolio is whole loans, a spokeswoman said.

Both agencies have been buying a lot of long-dated PACs as well as discount paper in 1998 such as 6 1/2 and 7% pass-throughs, said Ms. Koren. Analysts also said Fannie and Freddie were buying intermediate ARMs.

Fannie and Freddie both declined to discuss their investment strategies. But both were willing to discuss the marketing of their mortgage-backed securities to investors.

"Clearly, the 30-year fixed-rate product is the dominant one in is this market," said Gene A. Spencer, vice president of MBS investor marketing at Fannie Mae. He said that current coupon pass-throughs, and Remics or strips that are created out of them, are prevalent in the marketplace.

"With the extremely high levels of prepayments that have been experienced by the market, a lot of investors are looking to reinvest the cash that they have received from these prepayments," Mr. Spencer said. Through Apr. 23, 1998, Fannie 30-year fixed-rate 6 1/2s had $15.7 billion in MBS volume, and 30-year fixed-rate 7s had volume of $12.7 billion, Mr. Spencer said.

Freddie Mac is also seeing strong demand for 6 and 1/2 and 7% 30-year coupons , said Ed Albrigo, national director of securities marketing. Mr. Albrigo said there is increased demand by investors for 15-year coupons because of dropped rates and prepayment considerations.

"There is a lot of production in the 15-year coupons and there is some good demand for it," he said.

With the budget surplus, the Treasury no longer has to issue as much debt, so investors are turning to other types of debt investments including mortgages, and asset-backed securities, Mr. Denton of PNC Mortgage said. But the largest sector is the mortgage-backed securities debt market, he said.

PNC Mortgage in Vernon Hills, Ill., a subsidiary of PNC Bank Corp., has found that the whole loan market's intermediate adjustable-rate mortgages have been particularly attractive to investors, Mr. Denton said.

"The whole-loan market has been very active this year and that group of investors are your traditional savings and loans, commercial banks, insurance companies, and REITs that buy whole-loan ARM products," he said.

PNC has been an active buyer and seller of whole loans , he said. "It's a dynamic market and definitely one which is very much 'rock and rolling.'"

"There's been a much bigger growth of mortgage assets being put into commercial banks' portfolios," Mr. Denton said. "I think it's because their consumer lending businesses have been flat and because of their desire to grow assets and to do so with less risk," he said.

In the mortgage-backed securities market, PNC Mortgage is also selling a lot of conforming and jumbo intermediate ARMs and fixed rate securities, he said. The conforming loans are sold to Fannie and Freddie up to the $227,150=limit and the jumbo loans, above $227,150, are sold directly to investors, especially banks, Mr. Denton said. These are private label securities backed by individual issuers such as PNC and are usually structured into a pool through a Wall Street dealer, he said.

As banks have become more effective at managing their liability side, and they have purchased longer assets, said Mr. Denton. Banks are also involved with adjustable-rate mortgages because of their demand for yield. "They're trying to manage their growth and at the same time their interest- income return in the mortgage area because they have become comfortable with it," Mr. Denton said.

"Investors have been going back into mortgage related products. Judging by the spread between mortgages and Treasuries, people have been selling Treasuries to buy mortgages," said John DiVito, assistant portfolio manager, SunAmerican Federal Securities in New York.

"We have made some adjustments. We have looked into mortgage products," said Mr. DiVito. He helps to manage the Federal Securities A&B fund, a $60 million portfolio primarily containing government-quality paper.

But investors are also feeling drawn to the hot commercial mortgage- backed market. "It is drawing money from residential mortgages and also from asset-backeds," said a mortgage analyst for a major portfolio management firm. But he said that overall there has been a lot of appetite for strong spreads, and that bodes well for mortgages, among other securities.

Nathan Hasson, vice chairman and treasurer at Republic National Bank of New York, is purchasing Ginnie Mae 7 and 7 1/2% coupons with slight premiums.

"They're more defensive in a slightly higher interest rate environment," Mr. Hasson said. The extension risk and the acceleration risk are smaller than with lower coupons, he added.

"New mortgages now are being written about 7 3/8% so we are pretty well protected against refinancing with those coupons," Mr. Hasson said. Republic has nearly $11.8 billion in mortgage-backed securities as of Sept. 30, 1997, making it the fourth-largest bank holding of mortgage-backed securities, according to an American Banker ranking.

Mr. Hasson expects prepayments to slow in May, after the huge pickup during the last few months, he said.

Mr. Hasson also said that 30-year fixed rates currently have more value than 15-year securities and he advises staying away from adjustable-rate mortgages.

"There is a tremendous amount of interest in the short end of the curve, which would typically be five years in average life or shorter," said Steve Abrahams, a principal at Morgan Stanley.

Banks are good buyers of PACs, which are highly prepayment sensitive, he said.

Banks typically like short-duration assets like ARMs and short CMOs he said. "Both of those kind of assets have really been prepaying quite heavily," he said. And both have also been originated at some of the lowest volume levels reported. ARMs are paying off and are not being originated in any size to replace them, and CMOs are prepaying, so banks are engaged in buying activity to replace these assets, he said. Banks also hold about 20% of the entire amount of agency mortgages in the marketplace, said Ms. Koren of Prudential Securities.

Total-return money managers, pension funds, insurance companies, and federal agencies are the primary buyers on the long end, said Mr. Abrahams. He said these institutions were purchasing intermediate to long-end PACs. Money managers, he said, tend to be more opportunistic.

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