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Gold/Mining/Energy : Precious and Base Metal Investing

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To: aknahow who wrote (13216)	6/29/2003 7:34:50 PM
From: LLCF	Read Replies (1) of 39344

<Institutions making or writing adjustable rate mortgages take a smaller interest rate risk but a larger default risk.> Question and comment: 1.) Why is default risk greater with ARM? Comment: The i rate risk associated with a fixed rate mortgage is much larger and harder to hedge than most realize. These loans have 'put options' granted with them as part of the contract... ie. the lender is "short a put" termed 'pre-payment risk' in the media. This means that you can't just to some vanilla swap or hedge buy shorting a 30 year bond against it. You have 'negative convexivity' or are "short a straddle" and must use 'dynamic hedging'* if you can't cover the position with other options [reason FNM tries to float so much callable paper... then THEY own a 'call' covering lots of negative convexivity]. FNM and FRE DO NOT TELL ANYONE what they're position in the premium market is as far as I know... meaning they dont' divulge the extent of their negative convexivity and need for dynamic hedging. FRE's CFO made comments last year about concerns about liquidity in the fixed income market if things got out of hand due to the need for GSE's for dynamic hedging. This is the ONLY thing I ever say mentioned by any of the GSE's on the topic. BTW, the GSE's FNM and FRE alone have a Trillion in retained mortgages I believe, and another Trillion of stuff they've sold BUT retained the default risk if I'm not mistaken???? * dynamic hedging = selling or buying as the market moves to stay hedged... symptamatic of being short premium or otherwise needing to adjust positions as markets move. Example is Wells Fargo's "portfolio insurance" [a gross misnomer btw, there was no insurance] scheme which exacerbated the '87 crash. Thinking that dynamic hedging is 'insurance' is equivalent to thinking you don't need earthquake insurance because you live next door to a stone mason <NFG>. DAK

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