Bumpy Road for Mortgage-Backed Securities

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NEW YORK -- Tough times in the $2 trillion market for mortgage- backed securities may be about to get even tougher, as investors already smarting from hedge fund sales brace for a record pace of prepayments.

As homeowners rush to refinance their loans with interest rates near 30-year lows, investors are anticipating a surge in prepayments of mortgage securities. Those early redemptions hand investors their money back sooner than expected, leaving them to reinvest at lower yields.

"Prepayments are going to be very heavy, probably a record," in coming months, said Bob Wasilewski, who manages $2.5 billion in bonds at ASB Capital Management in Washington. Expectations for a surge in prepayments come at a time when investors are already shying away from mortgage securities and anything else riskier than Treasury debt. Troubles began in August, when Russia devalued its currency and defaulted on some of its ruble debt. That wreaked havoc among holders of mortgage bonds, driving some into bankruptcy and forcing funds, such as Ellington Management Group, to unload billions of dollars in securities to raise cash to meet margin calls from lenders. "I've been doing this for 18 years and have never seen a market like this, where liquidity is just not there," said David Brownlee, head of fixed-income at Montpelier, Vt.-based Sentinel Advisors, which manages $11 billion in mutual fund assets. "Hedge funds are just throwing things overboard." The hedge fund sales and the approaching wave of early redemptions has many investors refraining from buying mortgages, or cutting back on their holdings -- even though, in some cases, the securities are already as cheap as they have been in more than a decade relative to benchmark Treasury notes. The difference in yield, or spread, between Fannie Mae current coupon mortgage passthroughs and 10-year Treasury notes was recently 178 basis points. That's 113 basis points wider than the average over the past five years. "We have a model and it's screaming `cheap,' but we're afraid to be way ahead of the curve and buy now because the risk is too high," said Donald Ross, chief investment officer at National City in Cleveland, which has $23 billion under management. "We don't know how big the iceberg is." Some investors, including Mike Buttner, who manages $26 billion in mortgages for Charlotte, N.C.-based First Union, are buying mortgage securities with 6 percent coupons, which are backed by loans with lower interest rates that are less likely to be refinanced. Buttner said he's expecting "a big spike in prepayments in the next two months." Brownlee at Sentinel Advisors said he "wouldn't want to be in anything above a 7 percent coupon. You don't know where the prepays will be." The decline in mortgage rates to the lowest in 30 years has been driven by a rally in the U. …


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