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Minyan Mailbag - Nightmare Hedge:Part Deux



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Editor's Note: The following exchange is a continuation from a previously published article, Minyan Mailbag - Nightmare Hedge.

Thanks John,

I'd argue that the biggest risk for the
GSEs is not their potential mis-matches, but the risk of an economic downturn leading to increased defaults and falling home prices. If interest rates rise enough on ARMs, and/or enough people lose their jobs, the GSEs could have a big default problem. The national homebuilders seem to be set on building as much as they can, causing an oversupply problem and potentially falling home prices. Fannie's (FNM) and Freddie's (FRE) guarantee of mortgage payments has meant great profits in good economic times, but they haven't had to make good on the guarantee in a really big downturn yet, especially considering the rapid expansion of their portfolio in recent years.

Would you agree with that assessment, or do you think their derivatives portfolios are a larger risk?

Yes, this is their risk of prepayments when rates fall, which most likely magnified the spikes in treasury prices in 2003 and 2004, compounding their own problems because they are too big for their own good, and underscoring the flawed notion that they (and other large financial industries) can hedge away their risks. However, I'm more interested in the nitty gritty details what they are doing to hedge their $1 Trillion in mortgage portfolio investments against rising rates. To the extent that they do the standard banker thing of borrowing short to support a portfolio of long term mortgages, they also engage in swaps and other hedges to lower their risk.

I was wondering, based on your experience in the derivatives markets and because they are so huge, if you had any more specific insights into what the GSEs typically purchased as hedges and which rising rate scenarios might work out worst for them and best for their counterparties.

Below are your comments in bold with my thoughts underneath:

1. In order to hedge against shifts in interest rates, GSEs and mortgage companies use interest rate futures, options on futures, interest rate swaps, and options on swaps, and other OTC interest rate structures. The use of options is an attempt to reduce the negative convexity risk described above. But this comes with a cost: when they buy options it drives up the implied volatilities of options and the actual volatility of treasuries.

Yes, again the problem of their being to big to efficiently hedge.

2. If we had intimate detail of all the hedges and the underlying portfolio, then we could come up with a risk profile, but the GSEs are not required to report in such great detail. We do know that the notional value of derivatives (convexity) has sky rocketed over the last five years; we estimate that amount to be as much as $200 trillion, most of which are interest rate derivatives.

All those trillions in instruments give the holders a sense of security, but how great do you think the risk of counterparty default is there if we have a really big collapse in treasury prices and the dollar? Could many of those insurance policies end up worthless in the case of a real crisis (i.e. something much bigger than the Asian currency crisis of 1997 or the Russian default of 1998)?

3. GSEs and subprime lenders such as NFI

I have short positions in Countrywide (CFC), Irwin Financial (IFC), New Century Financial (NEW) and Novastar Financial (NFI), however, I don't think rapidly rising rates are bad for them, because that is what they've hedged against and because their profits come from the difference between long and short rates. What is hurting them most is the contraction of the yield curve. They made huge profits on the carry trade when margins were big, but now they've gotten tight, so it's hard to make money on new loans. Indeed, I think that their profits are grossly overstated because they aren't setting aside nearly enough in reserves. Much of their imaginary profits also stem from their growth. As long as reported profits on new loans exceed losses on older loans they can stay in the black. However, they are heading for a big double-whammy as rising rates cut into their ability to make new loans and rising defaults accelerate their losses on their old notes. The sector peaked last summer, and they started missing earnings estimates. I expect most of them to go bankrupt before this tightening cycle is over.

I was wondering if there was a significant class of hedge funds and other types of investors that had been taking the risky side of the interest rate bets to score easy short term profits. This would have been a great play over the past 4 years, and I could imagine some hedge fund managers getting rich by taking on too much of these risks, only to be the first to blow up when their leveraged bets blow up on them.

Do you think there is much exposure to this type of high risk strategy?

If rates do rise fast enough, I'd bet that the big underwriters (JP Morgan (JPM), Citi (C), etc.) would take a big hit. That, however, is the main reason why I don't think rates will rise too fast... at least not until the risk premium rises dramatically on swaps, options and futures.

4. I think everyone wants to know what that magical level might be, including me. But I do believe that there is a level and a rate at which things would begin to move that would precipitate the necessity to re-hedge violently. I suppose there are probably some folks somewhere working their spread sheets to try and calculate it, eh?

5. Volatility shifts in option prices should reflect that as well as liquidity shifts, aggressive moves by the Fed to stave off a cascade of negative convexity. We saw this in 1998. Moreover, as the derivatives market is so large, a transmission of risks is likely to cause anomalous behavior across asset classes.

And I'll be checking the Gazette to be sure I read about it when that volatility process gets going.

It would be quite a show. I just don't know how the show begins.

I suspect that the show won't be all that dramatic until the final scene of each individual act. I think all the character development stuff is taking place now with the slow rebalancing of reserve portfolios in Asia. We'll see.

Thanks again,
Minyan Rodg


I agree fully that the biggest risks are a downturn in housing; even a moderate one at this point could significantly increase defaults and cause a cascade effect. This is why the Fed needs to keep nominal asset prices high: income generation is not sufficient to grow the economy. The convexity risk is simply why the business model of the GSEs does not work: the cost of hedging is higher than they let on and could increase significantly if volatility in treasuries increases.

The GSEs for the most part I think try to hedge their duration risk through dynamic hedging. The have found this to be more than difficult and have more and more tried to offset their convexity risk by buying interest rate options instead. This has a cost and equates to the time premium they pay. I would say that they have been under more pressure lately to buy convexity to hedge versus dynamic hedging. As a guess I would say that they would now hedge 20-30% of the total risk through an "option".

The exact structure is most likely a "swaption", which is an option on a floating rate versus a fixed rate. I say this because if they did straight interest rate options they could be subject to closing marks: losses must be recognized when the contract closes. By using swaptions they have been able to delay showing losses because they had determined that they could roll those losses into a new contract. This is what they were nabbed on and why they had to realize $9 billion in losses.

By far the largest counter-party to these transactions is JPM, which probably controls over 50% of the OTC derivative market. We are long volatility in JPM.

I think these GSEs and mortgage companies are somewhat set up to make some profits as rates rise (in their hedges) because they know that is where their risk is. But a rapid and prolific rise in rates I don't think they are prepared for. They can handle a certain range, but beyond that things will fall apart. I don't know where that trigger is. I would think that the systematic risks are as high as or higher than they were in 1998.

There are two types of hedge funds that could be exposed to rapid changes in the yield curve and the relationship between corporate rates and treasury rates: fixed income funds and credit funds (high yield and distressed funds). Fixed income funds play the yield curve and credit funds bet on recovery rates and corporate spreads. Both use a lot of leverage and both are exposed to rapid changes in interest rates and various relationships within.

...and lastly how it will unfold. Scott comments often on how markets actually work. An illustration of how people don't understand this is the following comment I read in the Financial Times by a currency trader (paraphrase): "It is everyone's best interest right now to not rock the boat and go along with the program (referring to the continuation of Asia in financing our trade deficits)".

Markets ultimately are very self serving where participants are going to do what is in the best interest of themselves. If that is in agreement with toeing the line, then they will. But when there is a first participant who deviates, this may cause a second, and a third, and then very quickly the market turns as it realizes it is all on the wrong side. This is called compression and I have described it before. This is why I continue to watch the dollar yen for signs that that first and second and third participant are abandoning ship.

Everyone can say they will never abandon ship until it begins to happen. But once it begins, people will be surprised at how many and how quickly they jump.

Prof. Succo

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