Mortgage-backed securities investors have been driven to the sidelines by prepayment risks associated with unknown future federal policies and the pending fiscal cliff, according to analyst Nanlan Ye with investment manager TCW Group.

Following the presidential election, Ye says the mortgages basis outperformed, but MBS investors eventually cooled their heels on all the uncertainty.

"Long-term supply and demand technicals remain highly positive for the agency MBS basis, but short-term volatility in MBS performance is likely to remain high as we approach the year end," he wrote.

Lower coupons have been outperforming higher coupons with Fannie Mae 3% rate coupons and 3.5s gaining about one to four ticks when compared to 10-year Treasuries, TCW said.

"Due to the higher than expected prepayment speeds on pre-HARP premium coupons, Fannie Mae's 5s through 6.0s lost 24 ticks, 34 ticks, and 39 ticks, versus their treasury hedges, respectively," added the research firm.

After learning that the Federal Housing Administration is facing a $16 billion deficit in its insurance fund, TCW became aware of the fact that most of the losses are tied to 2008-2009 borrowers, where the fund could lose up to $25.5 billion.