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Politics : Ask Michael Burke -- Ignore unavailable to you. Want to Upgrade?

To: Cynic 2005 who wrote (29436)	6/29/1998 5:29:00 PM
From: Knighty Tin	Respond to of 132070

MMV, The Japan bank rumor is not true, but the story of the hedge funds that use brain-dead mortgages is at least true in some cases. First of all, we have to remember that there is somebody on the other side of every trade, so if a hedge fund is hurting, another hedge fund, a brokerage firm, or my maximum income partners (hooray!), are doing very well, thank you, sticking it to them. I do believe that if enough hedge funds get into trouble, there would be a meltdown, but those that use mortgages extensively are in the minority. Basically, these guys were buying the brain deads and shorting Treasuries or some other real fixed-income instrument against them. They discovered that mortgages only work when they sit absolutely still. Then you can capture their extra "yield" vs. Treasuries and pocket the difference. And, since this is a "low-risk" trade, you can leverage out the wazoo. And since these guys grab 20% of profits (so do I on my partnerships, so that part isn't bad), the wazoo is Archimedes friend. Sadly, this spread they put on does not work when rates either go down or go up. When rates go down, as they have recently, folks re-finance at much lower rates and the mortgages cash out in the hedge fund's face. They now have to re-invest at a lower rate while their Treasuries or other real fixed-income product, is seeing its price soar. When rates go up, folks remember that all the crapola about duration and quantitative return expectations don't work, and they stop treating mortgages like 7-12 year securities and start treating them like longer term paper. So, their asset is short term paper when they are right and long term paper when they are wrong. For this awful situation, they receive a temporary yield premium that is awfully puny for giving up all the upside while taking most of the risk. When paired against Treasuries, and rates go down, that leverage eats their lunch in no time. As a long term fixed-income investor, I know that you can get away with a lot of crapola in that business. But one thing you cannot do is expect your customers to accept losses of 20-59% because you guessed wrong with their money. And when they start to bail, it makes the situation worse. MB