A lot of analysis that gets written will refer to "technical factors" driving valuations.  What this is referring to are situations where unique factors are impacting valuations.  The classic business school example that comes to mind is the unique case of "flower bonds."  These were special issues of low-coupon U.S. Treasuries that could be used to pay Federal estate taxes at par value; as a result, they traded at extremely low yields.  The unique nature of the mortgage and MBS markets means that there are a number of situations that affect market levels, and understanding them can help lenders and secondary market managers do a better job of managing and hedging their pipelines.

An MBS-specific example of technical factors is so-called "convexity" buying and selling.  This refers to the fact that large bond market rallies and selloffs tend to be self-perpetuating; big market moves often push yields beyond levels that can be explained by changing economic expectations. Readers of the MBS Commentary channel will have encountered this phenomenon as "snowball" selling or buying. 

To understand this, we first need to review several market fundamentals.  Remember that the MBS market is huge, second only in size to the Treasury market.  Roughly $5.5 trillion in MBS issued under the auspices of Fannie Mae, Freddie Mac, and Ginnie Mae are outstanding.  (The MBS market used to be larger than the Treasury market, but a few years of trillion-dollar deficits changed that dynamic.)  

In addition, mortgages are prepayable at the option of the homeowners.  Any investor or portfolio manager holding MBS or mortgage-related securities has to make some judgment on how rapidly their holdings will prepay.  (That's why prepayment metrics are referred to as "speeds.")  When interest rates decline, investors will assume faster prepayment speeds for their holdings, which means that their portfolios are effectively getting "shorter" in both average life and price sensitivity to rate moves, i.e., duration.  If rates rise, the opposite happens; investors assume slower prepayments, which in turn extend the average lives and durations of their holdings.

This means that investors both large and small need to adjust the duration profile of their portfolio when interest rates change, especially if they are "index" investors that track the duration of major market indices.  Since rate declines (i.e., rising bond prices) are associated with shortening durations, investors need to buy assets in order to maintain their portfolio's duration, perpetuating the rally.  Alternatively, rising rates are associated with the selling of duration (either MBS or any fixed-income asset with positive duration) by investors, pushing bond prices still lower.  

These activities tend to push market moves beyond what would be associated with simple changes in expectations, and are referred to as "convexity buying" or "convexity selling" because they result from the negatively-convex nature of MBS.  (I'll discuss convexity in a future post.)  Understanding this phenomenon can help investors gauge the intensity and duration of market moves, and adjust their responses accordingly.  (Note that the fact that the Federal Reserve holds over $1 trillion of agency MBS has dampened this response a bit; the Fed is a "passive" investor and does not adjust its holdings to changing rate levels.)

Next Time:  Technical Factors Part 2: Dollar Rolls