Bumpy road for mortgage-backed securities

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.S. Treasury market. As investors shunned riskier investments, 10-year Treasury note yields -- a benchmark for mortgage loans -- fell to a more than 30-year low of 4.16 percent on Oct. 5, pulling mortgage rates down as well. The average rate for a new 30-year mortgage fell to 6.49 percent two weeks ago, the lowest since 1968, according Freddie Mac, citing figures from the Federal Home Loan Banks System. That may make refinancing worthwhile for homeowners with mortgage loans of 7 1/2 percent to 8 percent -- which back 7 percent and 7 1/2 percent mortgage passthroughs. The Mortgage Bankers Association of America's refinancing index, which measures refinancing applications received by mortgage bankers, rose to an all-time high last week of 4389.1. An increase in the index typically heralds faster prepayments on mortgage securities. "We should see record (prepayment) numbers for November and December" for 7 percent and 7.5 percent bonds, said Dale Westhoff, director of mortgage research at Bear Stearns. "You better have a good prepayment model if you're buying 7 percent and 7.5 percent coupon bonds," ASB's Wasilewski said. What's more, while mortgage rates rose last week, they may head lower again soon. The Federal Reserve Thursday cut its target for overnight lending between banks by a quarter point to 5 percent, its second cut in less than three weeks. Many investors foresee more cuts in coming months as the central bank tries to ward off a recession. The mortgage market is already reeling from sales by hedge funds and other investors in need of cash. Ellington, based in Old Greenwich, Conn., last week put up for sale about $3 billion in mortgage securities. The sales come at a time when securities firms that finance hedge funds, which speculate in markets on behalf of wealthy individuals and institutions, are tightening their lending standards, and demand for the bonds has plunged. Earlier this month, Criimi Mae, the biggest buyer of risky commercial mortgage-backed securities, filed for Chapter 11 bankruptcy protection following losses on its investments. The market for commercial mortgages has also been hurt by speculation that hedge fund Long-Term Capital Management -- which was taken over by lenders last month to avert collapse -- is sitting on billions of dollars of the securities that it will eventually unload. Taken together, all these problems suggest the mortgage market's woes aren't yet over, investors said. "Mortgages do look attractive, but there are problems out there," said Mitchell Stapley, who manages about $2.5 billion in fixed- income securities for Lyon Street Asset Management in Grand Rapids, Mich. "They've looked attractive for the past two months and they continue to get hammered."

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