Mish, Ok know you've looked at this, but if mortgage convexity and duration extension is taking off, how will that play out in Treasuries? Wouldn't that tend to force selling in the long end, say 5 years and out, but possibly result in a scramble for shorter Treasuries (*), say 3 and under, as short duration mortgage backed disappears (because of extension of duration, caused by fewer refis and transactions). In otherwords big curve steepening caused by a glut of longer dates, and fewer shorter or more accurately a disappearance of short maturities? All of a sudden, mortgage holders are going to own long duration portfolio, and of poorer credit.
If so the paper to own would be T-Bills and 2 years, possibly 3 years. In the later, one would wait for prepayments to really tank (say below 1500 refi), avoiding anything longer.
Can you find out how much mortgage duration has blown out in the last several weeks, especially this week? This could get interesting.
(*) relatively, since the FCB activity has to be taken into account. FCB may have bought agencies ($391.6 billion), because they like short maturities, and now find they have longer maturities.
Yes, I have looked at this and I also reported that Fannie Mae and Freddie Mac heightened the movements of treasuries above certain yields and below certain yields. This was the sunject of debate just days ago. I believe it was Win-lose-draw strongly disagreeing with my position. I will print some snips below that suggest that I am correct.
Right now, I am only aware of two levels and they are (on the 10 yr note) at 3.92 and 4.44. No one knows exact levels probably other than FNM but it is my understanding that refis drop significantly above 4.44 and increase significantly below 3.92. I have also contended that multiple fast moves between these levels has cause Fannie Mae to lose its ass on "dynamic hedging". My contact has really good sources so I presume those numbers are correct.
This might sound strange but I believe more selling will result in even more selling by FNM. Right now it seems that players have stepped aside because of the debt that has to be rolled over as well. It seems to me that Aunt Fannie is being set up for one monstrous whipsaw once again after this plays out. Yes it is "happening" at the long end of the market not the short end but except for 1 year duration and under it is probably affecting them all.
The question is how high can it get?
That answer is unknown. If some extremely bond friendly news comes in we can see one hell of a rally, oddly enough forcing FNM to take off the hedges it just put on at 4.44 or wherever.
Then I see no reason why if a treasury auction goes bad we do not whip right back over 4.44 with Aunt Fannie not being able to find her ass with both hands.
As for "Can you find out how much mortgage duration has blown out in the last several weeks, especially this week? This could get interesting.".
I believe my source knows that information. Unfortunately I am quite sure he will not give it out for free. He makes a ton of money selling info like that to hedge funds. He is willing to share some things and that is how I came to understand the general levels around which Aunt Fannie has problems.
If so the paper to own would be T-Bills and 2 years, possibly 3 years. In the later, one would wait for prepayments to really tank (say below 1500 refi), avoiding anything longer.
I happen to like the entire curve between 1 year and 5 years. The safest plays in there is the shortest obviously but if we invert, one is missing a good opportunity to lock in yields. In that regard 2 and 3 years could be an ideal compromise, but I must point out that Bill Gross was hyping that exact timeframe on Tuesday (I saw him on Bloomberg TV). I suppose that could be good or that could be bad.
Yes it could get interesting but you also know my position. This is an inflation scare and it is almost silly in that it is coming AFTER 12 hikes with housing appearing like it is ready to fall off a cliff and if you did not notice, tons of retail layoffs noted by Challenger. What does that tell you?
Following now are the snips I put together in support of my belief that Aunt Fannie and Uncle Fred are getting whipsawed to death shorting treasury yields higher and buying tresury yileds lower, effectively shooting themselves in the head.
Here goes:
Mortgage-backed securities are held by a variety of investors, although there are several large participants in the market. Fannie Mae and Freddie Mac, the two largest mortgage holders, had a combined $1.38 trillion worth of mortgages and MBS in their portfolios at the end of 2002. Other large MBS holders are commercial banks, which are attracted by their superior yields and little or no credit risk.
The increased size of the mortgage market has brought with it an increased need among mortgage holders to manage interest rate risk, taking into consideration the effects of prepayment risk. Mortgages and mortgage-backed securities have what is referred to as “negative convexity,” which means that the price of these securities is concave in the market interest rates, in contrast to the convex relationship between the price and yield of a typical bullet debt security. The negative convexity arises from the ability of mortgage payers to refinance their mortgages at par value. As mentioned above, this prepayment ability implies that the typical U.S. fixed rate mortgage embeds a short position in a call option (held by the mortgage payer). This option becomes more valuable as market interest rates fall, hence limiting or even reversing the capital gains on the mortgage security. The increased prepayment risk associated with the decline in interest rates also causes the duration of the mortgage to shorten, thereby changing the interest rate exposure of the investor’s portfolio going forward. These effects operate in the opposite direction in response to an increase in
interest rates: The duration of the mortgage will increase, and the decline in its price will be more pronounced than for other “positively convex” fixed-income securities.
It is likely that mortgage holders will attempt to offset some of the variation in duration that results from this prepayment risk. This is clearly the case for Fannie Mae and Freddie Mac, for whom we have some public information about their hedging activity. Indeed, both of these institutions have guidelines by which they seek to keep the net total duration of their balance sheets within a specified range around zero, thus requiring them to hedge or dynamically offset some of the changes in duration arising from shifts in prepayment risk. Market reports suggest that there are other large participants with a similar trading strategy, although not on the same scale as these government-sponsored enterprises.
One of the most straightforward approaches is dynamic hedging. Under this strategy, investors would buy or sell certain fixed-income securities or derivatives as interest rates change in order to offset changes in the duration of their mortgage portfolios. For example, if investors were hedging their mortgage holdings by shorting other debt instruments such as Treasuries or agencies, then they would have to reduce those short positions as duration declines and increase them as duration increases. This dynamic hedging strategy therefore causes investors to purchase debt securities precisely when rates fall and, conversely, to sell when rates rise—behavior that might amplify movements in market interest rates.
Because of the size of the MBS market, the potential magnitude of this type of hedging activity is large.
Another possibility is that mortgage holders could finance their portfolio with callable debt, or they could synthetically create callable debt by issuing non-callable debt and purchasing appropriate option instruments such as swaptions. Only large investors, such as Fannie Mae and Freddie Mac, appear to use outright callable debt, and they typically do so in a relatively small proportion since they can achieve the same result more efficiently in the derivatives market (see [4]). Thus, the more relevant type of hedging to consider involves the use of swaptions and other options such as caps and floors. Buying swaptions, for example, provides the mortgage holder with convexity, therefore offsetting or reducing the negative convexity of mortgages.4 Again, though, this strategy simply passes the negative convexity exposure to another investor, the one selling the swaption to the mortgage holder.
Overall, all of the static hedging strategies that are possible involve passing the risks associated with the negative convexity of mortgages on to other investors. Thus, these strategies likely will not mitigate the market effects of prepayment risk to any great extent.5 In the aggregate, changes in the prepayment risk of mortgages still result in significant shifts in the duration and convexity of the securities available in the fixed income market, as those shifts in duration and convexity flow to the household sector (or the mortgage payers in general). These aggregate adjustments, because of their considerable magnitudes, are quite likely to have implications for the behavior of long-term interest rates.
Fernald et al.,[2], describe the puzzling behavior of the yield curve following the 125 basis points tightening of target federal funds rate between February and May 1994.
At that time the yield curve failed to flatten, as it typically does when policy tightens; long rates actually started to rise in October 1993, and by May 1994 they were 133 basis points higher. Fernald et al. ascribe this atypical behavior to the selling of Treasury securities by holders of large fixed-rate mortgage portfolios and MBS dealers, who experienced an unexpected surge in mortgage duration and needed to sharply adjust their hedging positions as rates increased
....
Conclusions
The sheer size of the mortgage market implies that efforts by investors to hedge the prepayment risk of those securities can result in sizable shifts in the demand for other fixed-income securities. This paper presents statistical evidence that this hedging activity tends to amplify movements in the ten-year swap rate—as indicated by the increase in near-term implied volatility during periods when prepayment risk is elevated. The results indicate that these effects are statistically significant and considerable in magnitude, with recent amplification levels of between 16 percent and 30 percent. Moreover, we assume that the effects are short-lived.
federalreserve.gov
There you have it.
Given that ate affects are Short-lived and given that Fannie ends up buying back their own mortgage anyway it seems this dynamic hedging by Aunt Fannie and Uncle Fred is more than counter productive. They end up buying back their own freaking mortgage, at a lower rate then having to hedge that at those lower rates. Seems like a fundamentally flawed business if you ask me.
Mish |
