Bond Hedging of Mortgages

FT has a link that states the following:

"US mortgage securities comprise the world's biggest bond market, dwarfing the Treasury market. With $5,309bn of mortgage securities outstanding, and many of these hedged with other kinds of bonds, a crisis in the mortgage sector could spill over into other debt markets."

I don't understand how bonds and mortgages are so interconnected. I thought only mortgages are bundled together and shipped to FannieMae, etc.? And what do they mean that mortgages are hedges with other kinds of bonds? Is this the equivalent of asset allocation in the debt/bond side of the world?

Here's the link:

http://news.ft.com/servlet/ContentS...y&c=StoryFT&cid=1079420592390&p=1012571727143

 

It has to do with duration risk. Okay, just contemplating the subject did the trick. I can now go to sleep. Thanks and goodnight.

 

Sorry to put you out cold. But keep in mind I'm just looking for high level here. Are you saying they bundle bonds with mortgages to compensate for duration risk then? That means that if the mortgages default in the bundle then the bonds get taken down with them, i.e. they can be called?

 

A mortgage-backed security (MBS) has cashflows linked to the payment characteristics of the mortgage pool underlying them. They possess at least two kinds of risk:

1. Principal repayment risk - the par value of the bonds is a claim versus a trust that is backed by some entity, be it MBIA or Fannie Mae. You have credit risk to this entity. Typically this credit-risky component has (in my limited experience) been in line with swap spreads, say 30 - 50 bp.

2. Prepayment risk - the stream of coupon payments provided by the bond are generated in the following manner:

[morgage pool mortgage payments] -> [trust] -> [bondholders]

Now, you will observe that you can stop getting paid coupons if something happens to the mortgage pool's mortgage payments. The trust itself securitizes you against mortgage defaults, which is why (1) exists. However, individual mortgageholders have a single way in which they can deny you their contribution to your coupon:

They can prepay their mortgage.

If the yield curve drops to 2% and flat out to 30 years, many (although, historically, not all) people will refinance their morgages for a cash takeout. BANG. Your mortgage pool now has lost most of its coupon. And your current yield goes to zippity-squat. In effect, when you buy an MBS, you sell treasury bond options to mortgageholders.

Thus, the expected life (or duration) of the coupon stream emitted from a MBS is uncertain. There are mathematical models that try to help practitioners predict the expected life of their holdings. As you might expect, they are a little dicey, but they tend to work okay.

As the yield curve moves, so does the expected life of an MBS portfolio - therefore, portfolio managers need to extend or reduce the duration of their hedges. For example, if your portfolio's average life extends from 5 years to 10 years based on rates going wider, you'll need to cover some 5 years and sell some 10 years. [An explanation of why short treasuries are a good hedge to risky cashflows is outside the scope of this explanation but I'll explain later if you want.]

Functionally, FYI, the liquidity isn't really there in the treasury/futures market to hedge big moves, since the MBS market is so ginormous. So people hedge with interest rate swaps, which is why swap spreads exhibit directional volatility during times of rate volatility....

 

Thx for the great explanation. I am always amazed that there’s someone extremely knowledgable on et on almost any subject!

I reread the article and with your explanation I was able to understand what the gyst of what they were saying.

This is a very new situation for our country, right? We’ve never had interest rates this low and therefore a potential squeeze on banks like we have now, right?

 

Unfortunately I don't know a lot about financial history as I just started learning about finance two years ago, and in a very practical way. Rates have been this low before, but what is new is the massive amount of structured, securitized debt out there.

Because the amount of MBS paper exceeds the size of the treasury market, by a lot, and because (most) MBS holders need to respond to rate moves in the same way, interest rate volatility is magnified.

I'm not sure what the article meant, but one way to read it is, massive exposure to interest rate volatility and massively widespread, levered exposure to a single trade paradigm may produce a sort of cataclysmic event should the asset class suffer a major drawdown. Since so many entities are levered to the asset class, that could set off a chain reaction (MBS gets smoked -> big banks, little banks, hedge funds, high net worth individuals get smoked) that would be Bad.

 

It's not going to happen.

 

Can't see inflation kicking up rapidly enough to see rapid interest rate rises which I assume is what would cause the problems...

 

It's pretty hard to predict expressions of systemic risk factors, but yeah, I tend to agree... largely because I believe the "too big to fail" argument. (That is, our financial system cannot survive the failure of the MBS asset class and as such it will be bailed out by any means necessary.)

 

Is the crazy government bond trading that caused such havoc in the market last summer about to strike again?

We're not at that point yet but with yields on the key ten-year bond falling below 3.7% earlier this week, we may be getting close. Roughly put, at some point many homeowners with mortgages, whose rates fall with the ten-year yield, will start to refinance. That in turn will cause hedge funds that hold these prepaying mortgages to react in a way that may be confusing to outsiders but is second nature to traders: They buy ten-year bonds, pushing prices up and rates lower. This so-called mortgage hedging leads to more refinancing, and the cycle repeats.

If hedge funds help set off a refinancing boom, one big beneficiary will be mortgage lenders, such as Washington Mutual (nyse: WM - news - people ), Wells Fargo & Co. (nyse: WFC - news - people ) and Countrywide Financial (nyse: CFC - news - people ). And with consumer confidence falling and jobs growth anemic, refinancings that put dollars in consumers' pockets could prove crucial to keeping the economy growing.

How far can yields on the ten-year fall?

Van Hoisington, the contrarian manager of Hoisington Investment Management (see: "This Bond Bull Has Some Nerve"), says they'll hit 3.2% before the recovery finally gathers steam, thanks in part to mortgage hedging.

Others are skeptical. Sanjay Verma, head of government bond trading at Morgan Stanley, thinks any future compensating moves by funds are already priced into the bond.

To understand the impact of this hedging, consider the market chaos last summer. In June, Federal Reserve Chairman Alan Greenspan made comments that led investors to believe that he might raise his target for the federal funds rate sooner than expected. In response, ten-year yields began to climb, then suddenly jumped, catching many traders by surprise. They ended up rising faster in the following two months than in the infamous 1994 rate runup.

The cause was a puzzler at first but the effect was clear. Shares of big mortgage lenders sagged. The great refinancing boom was over.

The culprits for the rise, as it turned out, were traders at hedge funds and brokerages who had loaded up on mortgage-backed securities. When rates began to rise, they started selling ten-year bonds, or their equivalent, en masse. That depressed the bond price. And as prices fall, yields rise, which just causes more selling.

Why were hedge funds selling in the first place? When they buy mortgages they estimate when they expect to get back their principal. When rates rise, and refinancings fall, they suddenly face the prospect of having to wait a lot longer. Funds that need to keep their portfolio durations constant offset this by selling duration, which in many cases is a ten-year bond. The opposite occurs when yields fall. Duration shortens, and so they need to buy the ten year to extend it back.

This hedging didn't have as great an impact on rates when Treasurys were the big bullies of market. But now there are $5 trillion worth of mortgage bonds versus $3.2 trillion for U.S. securities, and the roles have reversed.