Dynamic Hedging of Mortgages, Risk Measurement Systems & Credit Derivatives
By James J Puplava CFP, November 20, 2002
Either, Or, but not Both
Take your pick: a stock market that rallies or a bond market that plunges. Stock prices and bond prices have been traveling in opposite directions lately. When stocks go up, bonds go down. Unlike earlier in the year when rates have been steadily declining, lately they have been bouncing back up. As of today the 10-year note, which is tied to mortgage rates, is back up over 4% and looks like it wants to challenge the 4.25% area of October. Coincidentally, the Commerce Department reported that home starts fell 11.4% last month to the lowest level since April of this year. Since the beginning of the year, 1.444 million homes have been started, making this year the strongest period since 1986. Housing has been one of the key pillars underpinning the economy. Housing makes up more than half of all U.S. construction and supports the economy through spending on other goods such as furniture and appliances. The back up in interest rates has definitely hurt the housing market.
Yields Are Rising
Long-term interest rates were beginning to back up by November when the Fed surprised the financial markets with another rate cut of half a point. This helped the bond markets rally and gave us a temporary reprieve. Now however, with the stock market rallying again, rates are backing up again as shown in the graphs of the yield on 10-year notes and the 30-year bond. The question on the minds of policyholders is which is more important to the economy--rising stocks or rising bond prices? It is the bond market that is more important because the government has a voracious need to finance budget and trade deficits. The bond market is also important to consumers who are using lower rates to extract additional equity out of their homes or to buy bigger and more expensive homes.
Things are Going Up
In addition to rising interest rates, the government also has a problem with rising commodity prices. Commodity prices, as reflected in the CRB, are rising to higher levels. Individual commodity prices such as wheat, corn, cocoa, and energy have risen even more. A falling dollar, rising interest rates, and rising commodity prices do not bode well for stocks. However, it is the bond market that could now become the Achilles heel for the markets and the economy. There is so much debt in the system that it has been necessary to bring down interest rates to keep companies and consumers afloat.
Companies that have overloaded themselves with debt have been tapping the bond market to raise cash instead of the equity markets. Qwest Communications today offered to pay investors twice as much interest to compensate them for swapping their old bonds for new bonds with new debt that is worth half as much as the old bonds. Even IBM is tapping the bond markets with a new $2 billion dollar offering. The bond business is one of the few areas on the Street where new offerings are bringing in money for investment bankers.
What happens to the bond market is critical for not only debt-Iaden corporations, but also debt-strapped consumers taking on more debt to maintain living expenses. Debt levels keep rising each month as consumers supplement income with additional credit. With a falling dollar, a falling bond market, rising commodity prices and a negative stock market, this year the choice for policyholders is obvious: prop up the bond market because it is more critical to the economy. The Fed chief said yesterday intimated that if they take the fed funds rate down to zero, they still have plenty of ammunition left. This "ammunition" is called monetization. The Fed chief said the Fed could start buying bonds all along the yield curve in an effort to pump up the money supply to control interest rates. The one caveat to this strategy is that you have to have willing lenders and borrowers. The limits to the Fed pumping the money supply have been the dearth in capital spending by business. This limitation also applies to consumers unless the Fed plans on offering homebuyers zero-percent loans with no money down and no payments for a year.
Looking at this market today, stocks exploded to the upside on speculation that the profit picture has turned around. Hewlett-Packard reported profits that quadrupled from a year ago as a result of aggressive cost cutting. The company has laid off 17,900 workers. Analog Devices reported higher than expected earnings as net income rose to $34.8 million versus $24.2 million a year ago. The stock is down 37% this year as result of weak demand for PC's and telecommunications gear. Wall Street, which was downgrading the chip sector last week, was more bullish on the sector this week. Wall Street analysts also upgraded the financial sector. J.P. Morgan, the largest owner of derivatives rallied $1.77 to $23.72. Wall Street firms believe that Morgan is setting itself up for a spectacular turn around in profits next year. The stock is down 35% this year.
What is occurring today seems eerily familiar to what happened to the market this same time last year. Stocks took off in the final quarter of the year in high hopes of a profit recovery. It was believed that the technology sector would lead the way out as companies stepped up capital spending. We later learned that wasn't the case. By mid-January, the real facts came out and the markets turned down. Next year will be a more difficult year for profit comparisons even on a pro forma basis or any other way you want to measure earnings in a more favorable light. Economic evidence shows that the consumer spending and the housing sector are starting to show signs of slowing. These two sectors, besides spending on autos, have held up the economy. However, one out of four American factories is idle. Companies are refinancing or raising cash from new debt offerings and next year is the year that pension contributions will be making front-page headlines. For now at least the markets are back to a feel-good atmosphere. That is more hollow rather than substantial.
There is another story here on the front pages ignored by the Street. That is the threat of terrorism. Most analysts don't follow political events. These ten-sigma events, when they occur, always take the markets by surprise. The six-day war, the resignation of a President, or 9-11 take the markets by surprise. Events outside the industry are very seldom covered. The one event that the markets aren't counting on is another 9-11 or something even worse, although the warnings from the FBI and the government show a heightened state of alert in the country.
Yesterday's Nyquist column was about a possible attack against the U.S. that has been planned for some time by Iraq and al-Qaeda. According to former congressional Task Force expert on terrorism Joseph Bodansky, Saddam Hussein and bin Laden have been planning an attack on the U.S. in an effort to provoke a conflict in the Middle East. The attacks on 9-11, according to Bodansky, were the warm up for bigger attacks to follow an attack on Iraq. It may be no coincidence that bin Laden shows up last week and makes new threats against the U.S. that will end up killing more Americans. The intelligence agencies have identified the voice on last week's tape as bin Laden, so what he says should be taken seriously. This isn't a man that says things just to get his picture in the papers.
As I wrote last Monday, there is now a circle of threats that is taking place. The U.S. is threatening Baghdad for good reason. In Bodansky's book, "Bin Laden: the man who declared War On America," the moves made recently by Iraq and al-Qaeda may be designed to create a catalyst, a crisis situation that pits the U.S. against Iraq, Iraq against Israel, and al-Qaeda against the U.S. Recently on the BBC, Iraq's Deputy Prime Minister Tariq Aziz indicated the coming war would be devastating for Israel and the U.S. Bodansky believes that spectacular attacks coming from al-Qaeda are in the works and are timed to take place in the event of war with Iraq.
As Jeff Nyquist points out in his article, bin Laden's message was one of justification, as if it was necessary to justify the horrible deeds that might be coming against the U.S. In Bodansky's new book, "The High Cost of Peace" he says that China, North Korea, and Iran are all working together against the United States. The goal is to evict the U.S. out of Asia and the Persian Gulf.
The threats now coming from al-Qaeda state, "Now it is your turn. You will be killed just as you kill, and will be bombed just as you bomb." The state of alert across the globe has never been higher. Police reinforcements have been strengthened in Germany, England and here in the U.S. According to Interpol, al-Qaeda is planning simultaneous attacks on there major continents. The intelligence networks know that something big is in the air. The nation's energy network is especially vulnerable. The Washington Times points out that intelligence agencies have detected surveillance boy terrorist suspects at three oil facilities in Philadelphia, Corpus Christ, and Valdez Alaska. Last week U.S. Security officials said that U.S. oil refineries and oil loading port terminals are all vulnerable to attack. The FBI's national Infrastructure Protection Center has stated that al-Qaeda is looking at targeting U.S. economically.
A refinery costs billions and takes years to build. They operate 24 hours a day, employing up to: 1000-2000 people. If attacked or destroyed, they would have the potential for a great loss of life due to their explosions or the release of gas. As Neal Adams in his new book "Oil and Terrorism" has pointed out, attacking the country's energy infrastructure would cause irreparable harm to our economy. It would be similar to a medieval siege. "If a group intent on attack hits one major choke point plus a few easy U.S. targets, our lives will change quickly and dramatically for the worse with no hope of recovery in the ear future." As Adams points out, a disruption of our energy infrastructure is equivalent to a siege.
U.S. oil and gas production is concentrated in three states-Alaska, Texas, and California. This is where a lot of oil and natural gas is produced and where the U.S. has a lot of refineries. In addition to refineries, the pipeline grid transports the bulk of energy. Pipelines are easy targets because of the length of the pipeline network. A drunken hunter who shot at the Alyeska pipeline in Alaska, shut it down for two days. Pipelines, loading ports, and most especially, refineries are now prime targets for al-Qaeda.
When oil is used as a weapon:
- Middle eastern Supply Sources and terrorists choose the time and the place.
- Oil users are without supply alternatives.
- Oil suppliers control the manner they choose to prosecute the war.
- Western importers, as the primary oil users, have not prepared for this type of attack.
- Oil stockpiles are virtually non-existent.
We are addicted to oil in the U.S., consuming over 25 percent of the world's oil. Fuel conservation is poor, energy stockpiles are inadequate, and as a result of environmentalism, the U.S. is self-restricted from increasing its own oil supplies. Lastly, we don't have systems in place to handle emergencies. The Strategic Petroleum Reserve (SPR) currently has about 53 days of supply. It takes 15 days to activate the reserve in the case of emergency. If oil supplies were disrupted here in the U.S., the withdrawal rate from the SPR is maxed at 4.1 million barrels a day. The potential shortfall between what the U.S. uses and imports a day could run as high as 1.9 million bpd. Any disruption of the world's key oil choke points listed below, when coordinated with an attack on any other supplies of energy here in the U.S., would cause economic devastation here in the U.S. and elsewhere in the western world. This is what al-Qaeda may have in mind all along. The key choke points around the globe are listed in yesterday's WrapUp. They are once again the Strait of Hormuz, Suez Canal, the Bosporus Straits, and the Malacca Straits. In the U.S. key choke points is the Alyeska Pipeline in Alaska. The Panama Canal is also important to the U.S.
"At Dawn We Slept"
As I have written over the last month on many occasions, the one event that nobody on the Street is expecting is a threat to our energy supply network or the nation's network. Instead, the consensus seems to be that if a war erupts in the Middle East, after a quick victory, Iraqi oil will flow freely with the price of oil coming down. Lower oil prices will act as a stimulus to the world's economies. What has not been factored in these calculations is what happens if things don't go as planned? If U.S. attacks, Iraq attacks Israel with WMD and al-Qaeda strikes at the U.S. Or what if the regimes in Saudi Arabia and Egypt fall, and the whole Middle East erupts into a conflagration that moves out of control? There are too many assumptions that are being made by the markets. They assume a perfect outcome. The U.S. may be walking into a trap. Yet on the other hand, given the plans of al-Qaeda and Saddam, it may have no choice. The only thing that comes to mind is "at dawn we slept'. Expect the unexpected.
I wrote in Rogue Wave/Rogue Trader Part 1 and Part 2 that unexpected events that are most likely to take the markets by surprise are a derivative mishap and a asymmetrical event. The recent events over the last week coming from bin-Laden, the FBI, Iraq and various intelligence networks, tell me that "the unexpected" can now be expected. As if to remind us of this danger, after Mr. Greenspan's speech yesterday warning of a possible derivative mishap, today Fed Vice Chairman Roger Ferguson Jr. alluded to these potential risks. As quoted from his speech below:
"However, some have raised concerns about the potential effects of the new risk-management techniques on the stability of the financial system as a whole. In effect, they argue that even if individual firms manage their risks prudently and effectively, the aggregate effect of their activities may be to make the financial system less stable. As I shall make clear, I believe the potential for the new instruments and techniques to produce instability has been overestimated. Nonetheless, the arguments deserve careful consideration, not only by policymakers but by financial industry professionals as well. If the arguments were correct, the new instruments and techniques would likely provide less protection than the firms using them assume.
Dynamic Hedging of Mortgages
The development of our market for home mortgages over the past two decades has dramatically altered the role of traditional financial intermediation by depository institutions. Let me illustrate this change. In 1980, depository institutions, primarily savings and loan associations, held two- thirds of home mortgages in their portfolios. That proportion has fallen to less than one-third today. Over the same period, the share of mortgages that are securitized has risen from 10 percent to 59 percent. Of course, intermediaries still playa vital supporting role in today's mortgage market by originating and servicing mortgages and by holding mortgage-backed securities in their investment portfolios. The challenge is in managing prepayment risk. Prepayment risk arises because mortgage borrowers have the right to prepay their mortgages at any time without penalty. The right to prepay is an enormously popular--and therefore almost surely a permanent--element of mortgage finance in the United States. When market rates fall, holders of fixed-rate mortgages find their principal being repaid as borrowers refinance with a new lower-rate mortgage. When market rates rise, prepayment rates drop dramatically.
One common strategy for hedging the interest rate risk of a mortgage-backed security is to short other fixed-income instruments, such as ten-year Treasury notes or interest rate swaps. But unlike most other fixed-income securities, mortgage-backed securities carry prepayment risk, which causes a change in the level of interest rates to change the amount of Treasuries or swaps one needs to short for an effective hedge. Specifically, when interest rates fall, prepayments increase, and as a result, the amount of ten-year Treasuries needed for the hedge falls. Thus, to reduce a short position in ten-year Treasuries, the hedger must buy ten-year Treasuries when their price is rising.
This is the point where concern emerges that financial engineering may lead to higher market volatility. Such "dynamic" hedgers of mortgage-backed-securities have adopted a strategy that requires them to buy bonds when the price of bonds is rising. Conversely, they must sell bonds when the price of bonds is falling. Put another way, they will always be reinforcing the current direction of the market and never "leaning against the wind." Clearly, if these hedging-related transactions are large relative to the underlying market, the hedging strategy could make significant demands on market liquidity and lead to higher market volatility.
The interest rate risk inherent in home mortgages is still present in mortgage-backed securities. The risk is simply transferred from the originator of the mortgages to an investor, who is presumably more willing and able to manage the risk. Nevertheless, even for the most able, managing the risk is a significant challenge.
My second topic today is the concern that common approaches to risk management, such as value-at-risk modeling, may be promoting herding behavior that can destabilize markets. The idea is that market participants who use similar risk management techniques may respond to a perceived increase in the riskiness of their positions by paring back the size of those positions and perhaps by paring back positions in other markets as well. Such a response, while rational from the perspective of individual market participants, may have the collective and unintended consequence of reducing market liquidity at the time when it is most needed.
My final topic today is credit derivatives. The credit derivatives market has grown rapidly over the past few years. According to statistics from the Bank for International Settlements, the notional value of credit derivatives outstanding rose from $108 billion in 1998 to $695 billion in 2001. According to market sources, this rapid growth continues unabated. Investors who sell credit protection can be motivated by a desire to earn higher returns in exchange for taking on more credit risk or by a desire to increase the geographic, sectoral, or other diversification of their credit portfolios by expanding the range of borrowers to which they are exposed. Insurance companies, particularly insurance companies from continental Europe, have been cited as large investors in this market.
In theory, the risk transfer associated with a bank's purchase of credit protection for its loan book should be effective. Instead of suffering a loss when a borrower defaults, the bank now suffers a loss only when both a borrower and its credit derivative counterparty default. The risk of simultaneous default is certainly much lower than the risk of a single default.
Credit derivatives, while making markets more complete, are not a panacea and must be used wisely. Most credit derivatives require the counterparty to make a payment to the bank when a credit loss or default occurs. For this type of credit derivative, traditional credit risk may reappear as counterparty credit risk, that is, the risk that the bank's counterparty will not fulfill its agreement to compensate the bank in case of a credit loss. The price of a credit derivative should take into consideration the credit risk posed by the seller of the protection and the appropriate default correlation, though default correlations are difficult to estimate precisely. But some credit derivatives, such as credit-Iinked notes, are pre-funded--the counterparty pays the principal up front and the repayment it receives at maturity is contingent on a credit event not occurring. Banks selling these funded credit derivatives have no counterparty credit risk at all.
The three topics I have addressed today--dynamic hedging of mortgages, risk measurement systems such as value-at-risk, and credit derivatives--are examples of newer risk-management techniques. Because these techniques are relatively new, regulators and market participants must work to build their understanding of how they function in differing economic environments. To date the new tools appear to demonstrate that financial engineering can enhance economic efficiency and, at the same time, contribute to financial stability by enabling firms to disperse risk throughout the financial system. All these new techniques were made possible by the fact that financial firms have had the latitude to develop them and pursue the ones that appear to be most useful. For all three techniques, the best approach for policymakers is to monitor developments, to insist that regulated firms practice sound risk management, to encourage transparency, and to avoid interfering with financial innovations that have the potential to improve financial stability, whether they occur inside or outside the realm of regulation." [Link to Ferguson Speech]
The Fed has alerted us to the problem, but believes the potential for risk is very low. Why, then, are they making so many speeches making reference to it?
European stocks fell, paced by Bayer and Carrefour before reports this week that may show growth in the region's economy isn't fast enough to lift revenue and profit. The Stoxx 600 Index lost 0.2% as auto shares including DaimlerChrysler led declines by 12 of its 18 groups. The Dow Jones Stoxx 50 Index shed 0.58 to 2603.31. Four out of eight major European markets were up during today's trading.
Japanese stocks advanced, lifting the Topix index from its lowest in almost two decades. Exporters such as Honda Motor Co. and Sony Corp. climbed after the yen fell against the dollar in New York trading. The Topix rose 1.7% to 830.82 and the Nikkei 225 Stock Average gained 1.1% to 8459.62.
U.S. Treasury notes and bonds found modest gains with the help of the weaker-than-expected housing data. The benchmark 10-year Treasury note rose 8/32 to yield 3.95% and the 30-year bond was 7/32 higher to yield 4.84%.
© 2002 James Puplava