April 26, 2004

Rates II - Mortgages and Musical Chairs

Dismal Science - By SUSAN LEE - April 26, 2004; Page A15

Financial crises usually come from left field. But that doesn't stop swamis from searching for the next trigger. Right now, the prospect of rising interest rates is focusing swamis on trouble in the bond market. Not a bad bet, since the past few years of falling rates have produced a ton of complicated ways to extract profits from fixed-income securities. Also not a bad bet since a forecast of higher rates is driving investors to unwind positions -- presenting a perfect moment to expose flaws in hedging and other strategies.

So it's hardly surprising that concentration of risk is Topic One. Consider, for example, a recent speech by the new head of the Federal Reserve Bank of New York. In lovely Fed-speak, Timothy Geithner blended concerns about the increasing vulnerability of the financial system to the growth in Fannie Mae and Freddie Mac and the high degree of concentration in the market for interest-rate options.

Mr. Geithner was vague in the extreme, but the details of his concern are laid out in a report from Credit Suisse First Boston. Here are the mechanics of a possible crisis scenario in which the particular nature of risk in the mortgage market becomes concentrated in the market for interest-rate options.

The chain of transmission starts with the mortgage market. (Bear in mind that, at some $7 trillion, this market is enormous.) Mortgages are of course wondrous financial instruments. They allow people, even those with humble means, to own a big asset -- a house -- without having to pay the full price up-front. But mortgages have an almost as wondrous property -- they give home buyers the opportunity to pay off before maturity. This prepayment option allows homeowners to transfer interest-rate risk to mortgage holders.

Holders of mortgage securities borrow money to buy those securities. If all goes according to plan, holders buy securities that yield more than they pay on their debt. However, when interest rates fall and homeowners prepay, mortgage holders find that cash flows have changed. What was a nice deal of, say, receiving 6% on mortgages and paying 5% on debt could become a less comfortable arrangement of receiving 5% on mortgages and paying 5% on debt. Not good. Or say that interest rates go up; then homeowners keep their mortgages and holders could find themselves getting 6% on assets but paying 6% on debt. Also not good.

Thus, having taken on interest-rate risk, owners of mortgage securities must hedge against that risk. One route to insure against a change in the spread between assets and liabilities is to use a derivative, usually involving Treasuries like interest-rate options. With these options, one party can insure itself against rising rates (or against falling rates).

All this is very cozy and safe in theory, but what about the real world?

The market for interest-rate options has two distinguishing properties. First, it is huge -- with a notional value of roughly $6 trillion -- larger than the amount of Treasury debt outstanding. Second, it is the only derivative market in which broker-dealers, collectively, take a position. Ordinarily, dealers just match buyers and sellers of risk, but in the interest-rate options market, dealers sell a lot more than they buy.

Simply put, prepayment risk has now been shifted to dealers. Dealers, in turn, try to dynamically hedge that risk. But their exposure is not symmetrical. Because they carry an inventory of Treasuries, they have a structural long position that gives them a natural hedge when interest-rates fall, but works against them when rates rise (they have to sell a lot of Treasuries -- and fast.)

This creates a powerful feedback loop. For example, dealers buy Treasuries when rates are falling, putting further downward pressure on rates -- and sell Treasuries when rates are rising, putting further upward pressure on rates. Although dynamic hedging is less likely to be a systemic issue when rates are falling, either way changes in rates are amplified by dealers covering exposure to interest-rate options.

What makes this feedback loop potentially lethal is that a change in rates requires an even larger adjustment in hedging portfolios. The CSFB report calls this "the embedded accelerator effect." The market had a tiny taste of this feedback loop last summer when interest-rates suddenly shot up and spreads in the swap market almost doubled in a few weeks. It was a stunning demonstration of just how sensitive the market is to rising rates.

Scary, sure, but two other aspects conspire to make the situation positively frightening. Over the past several years, coupons in the mortgage market have become concentrated, as owners rushed to refinance at the same time. Instead of a wide array of interest rates, coupons have collapsed to a very narrow range. This concentration increases the amount of hedging adjustments necessary for even a small move in rates.

Moreover, interest-rate options have become concentrated among a small number of dealers. Five, to be exact. And three of those five hold more than two-thirds of the options outstanding among FDIC-insured banks: JPMorgan Chase, Bank of America and Citigroup. (Even scarier, JPMorgan alone holds a notional amount of $4.5 billion -- that's 40% of the options held by banks and 27% of the total interest-rate options market.)

Simply put, any swami who wants to worry about the concentration of risk need not look beyond the mortgage market. Two highly leveraged hedge funds, Fannie and Freddie, are laying off giant amounts of risk in the interest-rate options market, where that risk is then redistributed to a handful of dealers. Throw in a little feedback loop, where changes in rates can quickly become a crack-the-whip situation causing massive instability -- and viola, giant liquidity risk.

Of course, Mr. Geithner isn't forecasting the end of the world or even a liquidity crisis. Nonetheless, his concerns should remind us that financial markets, no matter how sophisticated, cannot extinguish risk. Indeed, risk can be only moved around, from one player to another. But just like in musical chairs, when the music stops somebody is left standing.

Ms. Lee is a member of the editorial board of The Wall Street Journal.

Posted by iang at April 26, 2004 09:15 PM | TrackBack