Wednesday, December 17, 2008

Bifurcational hazard

Beware, there is likely to be a massive difference in MBS performance over the next year, as the government works hard to push mortgage borrowing rates lower. When a borrower repays his/her mortgage in part or in full, that repayment is passed through to the investor at $100. With almost all agency-backed MBS priced at $102 or above, investors will be taking a loss on every loan refinanced.

Mortgage prepayment speeds are especially dangerous for investors in collateralized mortgage obligations (CMOs). A CMO structure is dependent on prepayment speeds occurring within some range. But what we are likely to see is some pools pay extremely fast while others pay extremely slow. This kind of bifurcation could easily bust CMO structures and leave investors with cashflows wildly different from what was expected.

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