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Strategies & Market Trends : January Effect 2003 -- Ignore unavailable to you. Want to Upgrade?

To: Londo who wrote (548)	6/11/2003 1:16:28 PM
From: RockyBalboa	Respond to of 666

Interest Only - the interest stripped of a cert. Loses its value with rising interest rates as well as rising CPRs so it has sort of high gamma. Many mortgage funds are shorting IOs as long as I can think of - ie in an environment with rising CPRs. The best scenario for IOs would be stable, slightly rising rates but in any case with declining refi activity. Principal Only - they are the other part of the strip, like a govt zero with the additional kicker of early repayment (depending on CPR). So, it behaves a bit like a reverse-floater... CPR: Conditional Prepayment Rate, a key measure how much of the mortgages, aside from scheduled principal payments will be prepaid over a timespan of a year. The SMM (single-monthly mortality rate) is derived from the CPR and means "An SMM of w% means that approximately w% of the remaining mortgage balance at the beginning of the month, less the scheduled principal payment, will prepay that month." The CPR is key because it not only influences the values of the PO and IO but of the whole loan. Rising CPRs reduce the present value of the deal as less interest rate spread is earned over the avg life of the loan and secondly, in a normal yield curve environment the second order effect is that one has to offset the resulting duration gap from rising CPRs, as the whole loan loses duration (mostly by buying treasuries). In an evironment with rising rates, ie fed tightening the bolts finally, the CPR collapses once people find out that they can not refinance cheaper and in parallel the housing turnover shrinks a bit. With rising CPRs the mortgage lender faces the problem that he now must quickly hedge the resulting extension in maturities. He does this by buying back IOs (could be expensive) and/or selling govt bonds (could be cheaper). I'm not sure how he handles the short end but that can be done through MM futures. Issuing 10y mortgages might actually mitigate the risk profile a bit - they are less sensitive to changes in CPR from a duration standpoint so perhaps impact the curve much less as compared to 30y. Also see: riskglossary.com Or at FNM: fanniemae.com ---------------------------- btw the british pound gets a lil' lofty today but thats understandable as a new lending currency with rates unchanged. Perhaps another little UK treasury warning could to the trick, and clips off 2 cents... lol?