RateWatch #367 – Convexity Hedging
August 2, 2003 by Dick Lepre

What's Happening

The treasury market is now officially bearish according to StoMaster. The downcross on the monthly sto which occurred at the end of June is memorialized by remaining down-crossed at the end of July. The Treasury cash and future markets have experienced the largest monthly move in either direction in their history. The daily stochastic (one of our technical indicators) was at a record low. If this were baseball, it would be the equivalent of a 20 game (or worse) losing streak.

The BLS Employment Situation Report (see: http://www.bls.gov/news.release/empsit.nr0.htm)
is playing like a broken record: fewer total non-farm jobs (-44,000), all the loss is in goods
producing (-67,000),  some offsetting gain in services (+23,000), manufacturing was down 77,000.

So we have fewer folks getting laid off (yesterday's jobless claims) but there is little hiring.  This is typical of a recovering economy.  Jobless Claims slow down, business begins to gain some confidence, they start hiring and jobs go up.  If we really are having economic recovery we may not see gains in jobs for another 3-4 months.  For now we should regard the economy as showing the early signs of recovery.  Recovery is not a foregone conclusion but be are on the right road.

What the Heck Happen to Interest Rates?

A month ago we called for a bear market (based on the indications of StoMaster) but what has happened is "off the scale."  With inflation so low and the economic recovery so tentative why has so much happened so fast?

What is behind this?  The answer is, to a large measure, the mortgage business.  With rates
dropping and frequent refinancing happening, mortgages started to have life expectancies of
insects.  Portfolio holders sought Treasuries solely to increase their average duration.  This drove yields unrealistically low.  When Treasuries started to sell and mortgages looked like they would start to live more than a couple of years, these folks unwound their Treasury positions and the market free-fell.

To understand how this happens put yourself in the position of a person running a bank. You take in deposits, promising a puny 2.3% average yield, and you have overhead. You make money on interest. You have a mortgage loan portfolio that is paying an average coupon of 6% but rates keep falling and that 6% falls to 5% and looks as if it will keep falling.  These loans keep getting paid off because of things like that stupid newsletter that Dick Lepre sends out each week telling everyone to refinance the mortgage that they got 3 months ago. You need an asset to replace the disappearing mortgages because you need a certain average maturity on your assets. So you buy Treasuries.  This is a "replacement effect."

In addition, this falling interest rate market engendered hedging. Holders of and fixed income
security such as MBS (Mortgage Backed Securities) try to insure the value of their portfolios by
hedging.  Hedging is buying or selling another security to insure against the risk created by
a movement in rates.

MBS are securities collateralized by (for what we are concerned about) residential mortgages.
The holders of the securities are looking for future cash flow. The present value of that
future cash flow can only be calculated by estimating how long the cash flow will continue.
Cash flows from MBS are not as stable as the cash flows from government or corporate securities
because of the mortgage borrower has the ability to prepay the mortgage by refinancing or moving.

The popularity of high rebate, no-cost mortgages has made frequent refinancing popular.  There
is no decision such as "Does it make financial sense for me to spend $5,000 to lower my rate 1%?' The decision (from my experience) is this: is it worth the pain of copying my bank statements
etc. and signing those damn loan documents if the cost is zero and I lower my payment $100 a month?

Automated underwriting such an FNMA Desktop Originator has made it even easier by reducing
paperwork and perhaps the necessity of an interior inspection by an appraiser.

The trick for holders of MBS is, thus, developing a complex prepayment model.  Several things make MBS annoyingly different from other fixed income securities:

1) their cash flows are pseudo-random in the sense that they are unpredictable because they
result from the decisions of many families who are deciding to move or refinance.
2) the cash flows, relative to zero and coupon bonds occur much earlier in the life of the
3) the cash flows cannot be globally terminated as they would be if a) they were callable or
b) in the case of corporates - in default.

These annoying factors make MBS difficult to hedge.  There are (to be simplistic) two popular
types of hedges.  One is a duration hedge. This is when there is a mismatch in the durations of
one's assets and liabilities.  Buying Treasuries is an easy method of increasing the duration of
one's assets. 

The other hedging technique is convexity hedging. This refers to holders of MBS adding or removing duration through interest rate swaps or other derivatives.

I think that what we will soon discover - with a month of monumental movement in the market
- is that hedging fixed income securities is difficult and that neither of these techniques works perfectly.  There may well be some large financial institutions or, more likely, some hedge funds that are soon in peril as a result or not having a model that suited the events.  This is not to imply
that they were incompetent or irresponsible. What happened was the 1 in 1,000 case.

So Why Do Rates Go Up Faster than They Come Down?

In a word - fear.  Economic decisions are made by people and in addition to all of these nice
theories, strategies, and computer software, there are two very human forces that drive
decisions: greed and fear.  When assets have been appreciating (the dot-com thing) greed takes over and people are less risk adverse. They make high-risk investments.

When assets contract, fear takes over and risk aversion translates into selling.  An observation
that I would offer is that the effect of fear in a falling market is greater than the effect of greed in
a rising market.  This is entirely psychological. The way that I think of this is: this is the stuff
that you wake up at 2 A.M. thinking about. We can make seemingly rational decisions during the business day and go home holding certain positions but something (the subconscious mind or whatever it is that wakes you up at 2 A.M. reminding you that you forgot something) shakes you awake at 2 A.M. and tells you "Hey, Mister Smarty Pants, do you really think that it is wise to
be long in Treasuries when the 30-year yield is 4%. Hello!."

This psychological force is real and it causes people to alter their investment decisions so that they can sleep the next night.

So why did rates fall so fast?  Three things: efficient mortgage refinancing, the after-effects of hedging, and fear. 

Perhaps, somewhat more importantly, what I am implying is that little of this is caused by what is really happening with the economy. That may be the scariest part. The good economic news that we saw on Thursday moved the market to higher yields but it was hardly the root cause.

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