Old man lying
by the side of the road
With the lorries rolling by,
Blue moon sinking
from the weight of the load
And the building scrape the sky,
Cold wind ripping
down the allay at dawn
And the morning paper flies,
Dead man lying
by the side of the road
With the daylight in his eyes.

Don't let it bring you down
It's only castles burning,
Find someone who's turning
And you will come around.

Neil Young
"Don't Let it Bring You Down"
After the Gold Rush (1971)

Last Friday's announcement by the SEC of a civil lawsuit against Goldman Sachs (GS) for securities fraud did not surprise us. Nor were we surprised to see the markets trade off large on the news, evidence to us that there is a certain lack of conviction in the financials. Q: How can you have "normalized earnings" in an abnormal industry?

No, what surprised us about the SEC action is that it took as long as it did. Maybe surprised isn't precisely the right word, but you know what we mean. The inertia in the system seems to dampen reactions to extreme outlier behavior to a far too great a degree. This week in The IRA Advisory Service we discuss the implications of the SEC action and the likely impact on the OTC dealer community in the months and years ahead.

Readers of The IRA will recall back in 2004 when were stared to talk about the regulatory focus on complex structured financial products and the perceived reputational risk to the big firms arising from these unregulated, OTC instruments. Big thank you to Chuck Muckenfuss at Gibson Dunn for the heads up. The "advice" issued by all of the regulators ("Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities") was focused almost entirely on protecting the dealers from reputational risk and not on protecting investors.

The fact of the 2004 notice by the SEC and other regulators illustrates the problem. Regulators clearly knew that a problem existed back then, yet the SEC waited until April of 2010 to actually do something constructive to rebalance the equation, to lean just a bit more in the direction of investors and abit less in favor of the dealers. Keep in mind that it's not like the games played by GS and the Paulson organization were remotely unique. Just about every OTC dealer worthy of the description has at least one deal comp to this thing of beauty.

On March 31, 2010, Bob Ivry and Jody Shenn at Bloomberg published a very important article on American International Group and its losses from insuring collateralized debt obligations structured by, you guessed it, GS. Entitled "How Lou Lucido Let AIG Lose $35 Billion With Goldman Sachs CDOs," the article outlines the process whereby AIG was left on the hook for billions in losses on CDOs sold to TCW Group in Los Angeles.

Whereas in the trades with Paulson GS was helping a client create and then sell short a CDO that was being sold to another client, in the case of TCW the GS firm was helping a client buy toxic loans to be contributed to a CDO in the knowledge that doing so would cause losses to a regulated insurer, AIG. The activities of GS to harm AIG make the subsequent payments by AIG to GS, using money from the US Treasury, seem all the more outrageous.

But the other thing that really bothers us about both the TCW transactions and the more recent revelations about GS and the Paulson firm is the fact that the SEC apparently still does not fully understand the symbiotic relationship between the dealer and the hedge fund. In our view, the funds that were involved with these transactions and many, many more examples in the OTC marketplace, did not have an arm's length relationship with the dealer. Hedge funds exist at the sufferance of the dealers, who finance and execute and act as custodian for their various strategies and use the funds as short-term storage for inventory.

In the case of Paulson, the information provided by the SEC makes it seem as though Paulson was the party which initiated these transactions and, according to the SEC, paid GS $15 million to arrange and market these CDOs to investors. Paulson was also apparently working as an advisor to GS and collaborating with GS regarding investment strategy. A spokesman for Paulson told The New York Times that all of their dealings with GS and other parties were on "an arm's length basis." We believe that reasonable people can differ on this issue. We also suspect that the nature and the extent of the relationship between GS and Paulson will be the subject of extensive legal and political inquiry in the weeks and months ahead.

But for us, the bottom line is that hedge funds often times are merely extensions of the dealers with which they interact. It is often difficult if not impossible to tell where the dealer's interests end and those of the hedge fund begin, especially when the dealer and the fund seem to be working in concert to create securities that are being sold to third parties. This episode is a terrible mess and, to us at least, illustrates why the OTC markets for securities and derivatives need to be regulated out of existence -- or at least into compliance with norms of disclosure and fair dealing that would render such strategies impossible. If the global financial markets have been reduced to nothing more than beggar thy neighbor, then we all have a big problem.

Below we feature a comment from Alan Boyce, the chief executive officer of Absalon, a joint venture between George Soros and the Danish financial system that is assisting in the organization of a standardized mortgage-backed securities market for Mexico. Alan has worked in the past for Countrywide Financial, Bankers Trust and the Federal Reserve Board. Today Alan talks about the impact on the financial markets of the end of the Fed's quantitative easing operations. BTW, Alan will be among a very strong program at the next full-day program sponsored by the Washington DC chapter of Professional Risk Managers International Association and the FDIC Corporate University. Entitled "Issues in Securitization Symposium: An Open Dialogue on a National Priority," the event will be held May 3, 2010 at the FDIC's Seidman Center.

Click here for registration information.

Fed Mortgage Purchase Program Ended - Now What??
A Trader's Perspective
Alan L. Boyce

The effect of various Federal Reserve stimulus programs and open market operations over the past year is the subject of intense debate throughout the financial community. Here is my personal perspective as a trader and risk manager on what has happened and what will happen as and when the Fed's stimulus is withdrawn. This is not so much a prediction of what will be as a discussion of what we who operate in the market for mortgage backed securities all know -- but have chosen to forget recently.

The economists at the Federal Reserve Board and Reserve Bank Presidents think in terms of "factors affecting reserves" and "lender of last resort" when they look at the markets. This has led economists to place great significance on the withdrawal of two of the seven emergency lending programs begun in December 2007 and the rise in the discount rate on February 18th 2010. Aside from one speech by Brian Sack (December 5th, 2009 to the Money Marketeers), the Federal Reserve consistently has viewed its lending and quantitative easing (Fed Purchase Program or FPP) programs primarily from this broad theoretical perspective.

This author's perspective, by contrast, is that of a mortgage backed securities trader, who has the responsibility to trade, hedge and finance a position of complex, callable cash flows. Those cash flows come in the form of Agency MBS- either in settled form or in TBA forward delivery form. An MBS trader's primary concerns are duration risk (i.e. change in price for a change in yield), financing costs and the impact of changes in the slope and curvature of the yield curve.

An MBS trader is also very focused on the interest rate options market. In particular, he focuses his attention on the implied volatility of options on interest rate swaps (IRS). As an owner of callable mortgage backed securities he possesses an inherent short volatility position (i.e. negative gamma) and portfolio risk that is significantly impacted by movements in the implied volatility of IRS options.

Now some aspects to the current situation are clear from all perspectives. Over the last year the administration and the Fed have undertaken several measures, in the form of FPP, that are yielding short term positive benefits. Specifically:

1. Duration - the FRB/Treasury's programs have taken more duration out of the bond market than could be created in 2-3 years. This has kept long term interest rates much lower than they would otherwise have been. The yield curve has been artificially depressed, by at least 75 basis points, due to this reduction in the aggregate duration (price risk of the whole US bond market). This directly impacted credit and increased the price of all credit instruments.

2. Reduced Volatility - The result of the FPP removing a sizable chunk of mortgages out of private market hands is a reduction in the amount of convexity hedging in the near term. This drives down actual volatility in the fixed income markets. The FPP also forced many bond fund managers to replicate mortgages, in part by selling volatility, thereby compressing implied volatility. This became self-reinforcing as lower volatility allows for increased risk in portfolios which in turn reduces volatility as liquidity returns to markets. Volatility compressed across asset classes. And, reduced volatility directly impacted credit spreads, equity valuations, and commodity prices.

As we know, the FRB recently ended its purchase program. And this is where the mortgage trader's perspective may prove useful. A clear and consistent focus on mortgage duration risk shows us that we may face a series of large and as yet underappreciated challenges. The sooner we collectively understand these issues, the better we can address them. The rest of this article will describe my efforts to calculate the duration of the FRB/Treasury purchase programs and give my perspective on what will happen when the purchase programs end and underlying dynamics of mortgage duration assert themselves.

The Risk of the MBS

Annex 1 shows the MBS position of the FRB as of 12/30/09, which includes 'reported' settled positions and forward purchases (reported weekly). Essentially, this is the risk position of the Federal Reserve. An MBS trader (or investor) would calculate their risk using such a position sheet, in combination with various estimates of the duration of each underlying security. All of the analysis is done using 12/30/09 prices and durations.

By using OAD calculations from standard prepay models (which are too fast), the FRB had $460 million of price risk per basis point or "mm/bp" as of year-end. If you scale this up for the remaining purchases and the purchases by the Treasury Department, you get $776 mm/bp. This is using Option Adjusted Durations implied by pre-payment models that were conditioned on the housing market from 2002 to 2008. Those prepayment estimates are significantly faster than what has been experienced in the last two years.

If you use durations implied by coupon spreads (a pretty accurate measure of how the bond market views the current price risk on MBS) then your duration value of a basis point move in the markets or "DV01" jumps to $643mm. Scaled up for the whole program, you get $1,071mm/bp. If rates go up by 50bp, the FRB and Treasury would expect to lose $54 billion. If rates go up even more, assume durations extend and the losses on the next 50bp increase would be $75-90 billion.

If the FRB and Treasury were to hedge their negative convexity risk (bonds fall more than they rise for a given move in interest rates) they would need to buy interest rate options. The most likely option would be a 3yr into 7yr swaption, which currently trades at 5 points. If you hedged to coupon spread implied durations, you would be buying 3yr into 10yr swaptions, which currently trade at 6.5 points. There would be significant reflexivity if that amount of swaptions were bought (prices would be higher if there were more buyers). I estimate the average price paid would be at least 50% higher and have confirmed this with some of the best option traders in the world.

Bottom line: it would cost $142 billion for the FRB and Treasury to hedge the short optionality of their current MBS position.

The Risk of Other Bonds Purchased: Treasuries, Agencies, TIPs and Maiden Lane

These calculations are again based upon year-end positions. The durations are estimated by breaking each category of debt instrument into several buckets, estimating a duration for the bucket and then calculating a simple weighted average.

Asset	Position $B)	Duration	DV01 ($M)
Treasuries	707	5yr	353
TIPs	47	6yr	28
GSE debt	160	2yr	32
Other (Maiden Lane etc)	50	5yr	25
Total	964	4.55yr	438

The weighted average duration is 4.55 years with a DVO1 of $438mm per basis point. I will assume that since December, the remaining purchases have been in MBS instead of the other debt categories. Together with the scaled up to final size purchases of MBS, that would be $1,509 mm/bp or a $75 billion loss for the first 50bp move in the markets.

Accounting for the Net Duration Add to the US bond market

Mortgage market duration is estimated to have been roughly the same during the period of the FPP. There was no large scale refinancing, a sure-fire method to increase duration. The duration embedded in the existing mortgages increased slightly due to lower housing turnover and labor mobility. The recent GSE buybacks of >120 Day delinquent loans acts to reduce the duration of mortgages, as loans that were completely unable to voluntarily prepay are removed from the system.

Municipal market shrank in 2009. This was aided by help from the Federal government in the form of Build America taxable bond issuance and significant grants to State HFAs. Corporate bond market is small and did not grow in 2009.

Net Treasury issuance as $1.4 trillion, with a 4 year maturity and a 3 year duration. This is a net add of duration of which is $420mm/basis point -- the net result. The FPP took out $1.509 billion of duration per basis point. The mortgage market, municipal market and corporate bond market are estimated to have added zero net duration to the aggregate. The funding of a very large budget deficit required a significant duration add, $420mm/bp, by the Treasury Department.

Conclusion: the FPP reduced aggregate duration in the financial markets by almost 3.6x the duration that was added to the system during the period! This has kept long term interest rates much lower than they would otherwise have been. Without this, interest rates would have been higher, the yield curve would have been significantly steeper, and options would have been more expensive.

What are the Implications of Ending the FPP?

1) Duration: MBS widening out will result in lower prices for agency pass - thus, this will lead to an immediate increase in the calculated OAD of the aggregate mortgage index and drive the curve steeper. A steepening of another 50bp will cost the FRB another $84 billion. Agency MBS spreads are 90bp tight to their historical average spread of 120 basis points to US10yr. If spreads widen out to the average (ceteris paribus) the FRB will lose $147 billion.

Prepayment models used for convexity hedging are slow to adjust. Like historical models that failed during the crises of 2008, prepayment models will ultimately be seen as failing to recognize the enormity of the duration problem. Moving forward, refinance activity will surprise to the downside. Mortgage rates are coming off record lows. And, the creditworthiness of the delinquent homeowners still working through the system will impede refinance activity.

2) Options Volatility: The end of FPP shorting options will drive interest rate volatility up by 50%, making the cost of covering the short options position rise to $213 billion. Options traders tend to be agnostic as to what options markets they play in. When fixed income implied volatility increases, option sellers will be more likely to short options to the bond market and less likely to short options to the commodity, equity and foreign exchange markets. These options markets are all linked by investors. Expect implied volatility in all other markets to rise when the world's biggest sell program of long dated options ends.

3) Fiscal Policy: If the FRB were to just explicitly short payer swaptions, they would generate significant option premium which they would book as income. That income would revert to the Treasury department and the FRB would be wishing, hoping and praying that interest rates never move. Instead they are implicitly shorting the options through the unhedged purchase of MBS, generating cash income, which they report and remit to Treasury. If interest rates were to rise, the yield curve to steepen and/or interest rate volatility to rise, the FRB would suffer a huge mark-to-market loss. This would not be reported on their cash basis income statement. They would continue to book cash income, as long as the book yield of their MBS purchases exceeds their financing rate (paying interest on excess reserves). The Federal Reserve does not mark to market, instead runs a "cash income statement".

If you look at forward fed funds (Eurodollar curve less basis swap), the FRB will go negative carry in March 2015, where 3 month financing rates are forecast to be over 5% (just gets worse and worse from there). The point here is that mark-to-market accounting is an iron law. You cannot escape the losses just because you do not report them. If the FRB loses $200 billion on mark to market, there will be $200 billion LESS that they remit to the Treasury Department every year. That will require legislation to either raise taxes or lower spending by $200 billion (or run up bigger Federal debt to be paid back by another generation).

4) Excess Reserves: The end to the FPP will not change excess reserves, but who cares since they are being lent back to the FRB at federal funds target rate of 25bp. The Federal Reserve has plans to remove the excess reserves via reverse repo agreements (used to be called matched sales back in the non-borrowed reserve targeting regime). If the Federal Reserve wished to sell all of the bonds purchased, the expectation is that they would receive lower prices than they paid. The FRB would then need to issue "FRB bills" to soak up the remaining excess reserves, equal to the dollar loss on the round-trip bond trade.

When Will This All Unfold?

Using efficient markets hypothesis, this information is freely available so the effects of the end of the purchase program should be fully priced into the financial markets. So why didn't bonds fall dramatically in anticipation? There are a couple of potential explanations. First, financial markets are not efficient. They are not the best prediction of what will happen in the future. As recent events confirm, financial markets are quite myopic, able to see at most three months ahead.

And markets can be distorted when participants are incentivized by factors other than profit. The Fed's participation in the bond markets was not driven by a desire to profit from their purchases. They systematically purchased mortgages (and Treasuries) without regard to price. This can have a distorting effect that is not recognized until their influence on the markets is removed.

Second, their involvement in markets not only influences the prices of assets but they influence the behavior of other market participants. As discussed above, many real money buyers synthetically created mortgages because of the lack of supply due to FPP.

Finally, the Fed removed a huge stock of mortgages from the pool of available mortgages in the secondary market. The impact will be felt for some time until the flow of new mortgages begins to trickle into the secondary market providing additional liquidity. In the meantime, there is a real danger of a buyer's strike as participants sit back and wait to see what happens now that the program is finished. This is happening at a time that the economic data is coming in strong adding to pressure in fixed income markets.

If markets were to become unglued, the Fed may purchase more mortgages and Treasury debt. The question is how other central bankers and market participants would react to this. Foreign central bankers will likely snap and become sellers if the Fed decides to monetize more debt. Also, domestic and foreign market participants would likely take it as a sign that the Fed is politically unable to exit the mortgage market and unable to exit quantitative easing. As FPP ends, there is the real potential for unintended consequences in domestic and foreign markets.

Questions? Comments? info@institutionalriskanalytics.com

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