Rising yields keep mortgage players on edge

NEW YORK (Reuters) - Mortgage investors dealing with the fallout of the subprime crisis are facing an old nemesis: rising Treasury yields.

As a result, the Treasury market faces increased selling pressure as mortgage investors, who typically use U.S. government bonds or interest rate derivatives to hedge against effects of changing mortgage rates, are instead selling Treasuries to counter the impact of higher rates on their mortgage investment.

The yield on 10-year U.S. government bonds serves as the benchmark for 30-year fixed-rate mortgages.

Last week, mortgage investors pared their Treasuries positions as the yield on 10-year U.S. government bonds seemed poised to hit 5 percent, a level not seen since last summer.

"There'll be pressure to sell more as yields head up," said Richard Gordon, fixed-income market strategist at Wachovia Securities in Charlotte, North Carolina. "This low volatility environment has left some of these players unhedged."

A sharp rise in Treasury yields hurts the returns on the $10 trillion worth of residential mortgage loans and securities outstanding because rising Treasury yields result in higher mortgage rates and make refinancing less attractive for homeowners.

In turn, this phenomenon, known as extension risk, causes a drop in mortgage prepayments and slower repayments to investors. Investors often sell Treasuries to counter a spike in extension risk to reduce their duration -- or their portfolio's sensitivity in this case to rising interest rates.

Despite their current spike, Treasury yields remained within a narrow band over the past 10 months. Complacency over this range-trading led some players to decide not pay for hedges against a resurgence in yield volatility or to bet that volatility would fall.

Some players like mortgage companies, which had banked on yields to hold steady, scrambled to rebalance their portfolios in reaction to the persistent rise in yields, analysts said.

The recent selling tied to growing extension risk has intensified the upward pressure on Treasury yields. Yields have also been rising as players have flocked to a booming stock market, on competing supply from the corporate bond sector, and on fading prospects that the Federal Reserve would trim interest rates this year.

"Certainly if we hit 5 percent that will be a major signal for mortgage players to adjust their hedge ratios," said Fidelio Tata, an interest rate derivatives strategist at RBS Greenwich Capital.

If 10-year Treasury yields were to increase another a quarter point or so from current levels, it could unleash $50 billion 10-year Treasury equivalent worth of hedge selling, according to Tata.

However, some analysts do not expect more mortgage-related selling until Treasury yields shoot much higher.

"We aren't likely to see a substantial acceleration of hedging activity as the market sells off further, and thus this hedging will not contribute to an overshoot in yields," said Deutsche Bank analysts in a report released on Friday.

They reckoned that there won't be more Treasury hedges to be unwound because mortgage players bought Treasuries to hedge against convexity risk -- the opposite of extension risk when yields are falling -- when 10-year yields fell to 4 percent in 2005.

"Thus the need to hedge convexity actually declines as yields rise," they said.

Still, the mortgage sector may be a catalyst for higher Treasury yields, Deutsche analysts said. More homeowners with adjustable-rate mortgages will likely switch to fixed-rate ones in the coming months when ultra-low teaser rates on their adjustable loans expire, they said.

The pressure on Treasury yields would be compounded if the 10-year yield hit 5 percent, some analysts said.

"There could be some pain at 5 percent," said Wachovia's Gordon.