Monday, July 1, 2024

The Convexity Maven Is Perplexed

Markets can be wrong, "the truth is in the price" only some of the time, and there is something weird about how mortgage backed securities are being priced.
Harley Bassman, the Convexity Maven, knows a heck of a lot more* about packaged products than I do, but the fact he's been making this pitch for a while now leads one to consider the MBS trade as an example of the Climateer theory of wrongness: He is either wrong in the underlying thesis or he is wrong in his timing.

And I don't know which.

Anomalies that don't disappear over time elicit two emotions, fear that one might be missing some key factor which will become apparent only after one has committed a substantial fraction of one's net worth to the trade, and greed-based intrigue because it is in the interstices of the matrix and their intersection with understanding that alpha is found.

Or something.

From The Convexity Maven, July 2:

“Of Horses and Water”

I am sure you are well familiar with the expression:

“You can lead a horse to water; but you can’t make it drink”

After raising four strong-willed children, my version of this idiom is:

“You can lead a horse to water, chop off its head and fill it with cement,
drop it into a lake and it still will not drink”
. [Hat tip to Don Corleone]

Today we consider why Mortgage-back Securities (MBS) are still trading nearly
two standard deviations wider (higher in yield) than their historic average, nearly
two years after the Federal Reserve Bank [FED] started their tightening cycle.

We also consider why Investment Managers are not scooping up MBS to replace
Credit bonds (that can default) when confronted by a FED that is standing on the
monetary brakes.

As a reminder, these are NOT the infamous sub-Prime mortgages that collapsed
the housing market in 2008 presaging the Great Financial Crisis (GFC). Rather, a
single MBS is a collection of perhaps 10,000 standard 30-year mortgage loans
made to “prime” borrowers (FICO above 720) that are “wrapped” by Fannie,
Freddie or Ginnie (GSEs) so there is absolutely no default risk.

If you think one of these GSEs (Government-Sponsored Enterprises) can default,
I advise you to gather cans of tuna, a gun, and small denomination Gold coins.

These borrowers have the right (option) to prepay (or refinance) their loan at
any time for any reason with no penalty.

It is this prepayment uncertainty that creates the extra yield for owning MBS.
When one buys MBS, they do not know if that bond will pay off in two years or
thirty years; it is all at the discretion (option) of the borrower.

One can roughly model MBS as a “buy-write strategy” where one:
1) Buys a ten-year US Treasury (UST) at a price of 100
2) Sells a three-year expiry call option, struck at 105

It is the confluence of Interest Rates and Implied Volatility that creates this
embedded option’s two most important “values” – its price and its duration
(delta). It is also this option that creates the negative Convexity profile for MBS
where its upside price is capped near 105 while its downside is substantial.

The Asset Allocation Decision
When deciding how to allocate among various fixed-income (bond) assets, there
are only three risk vectors to consider:

1) Duration – When one receives their money back;
2) Credit – If one receives their money back;
3) Convexity – How one receives their money back.
When a bond matures is often used as a proxy for Duration risk, but more
precisely it measures a bond’s price sensitivity to interest rate changes.

Credit risk measures the chance of a default and the loss of one’s investment.

Convexity risk is a bit tricky since it is mostly found embedded into callable
bonds and can be a challenge to measure without a fancy model. [Thus, the
employment of “quants” to discern a bond’s Option Adjusted Spread (OAS).]....

....MUCH MORE (11 page PDF)
*Our boilerplate introduction to Mr. Bassman:
...Wall Street loves to make convexity sound complex (I suppose it’s so they can charge higher fees?). We speak Greek (calling it “gamma”), employ physics as a metaphor (analogizing to it “acceleration”), and use mathematical definitions (since it is the second derivative of the asset’s price change).

Pish, posh. An investment is convex if the payoff is unbalanced for equally opposite outcomes. So if there’s the potential to earn a profit of two on a bet versus a maximum loss of one, the bet is positively convex. If you can lose three versus making two, it is negatively convex. That’s it. The rocket scientists are called upon to help (fairly) price the cost (value) of such possible outcomes. This is why the expansion of derivative trading in the 1990’s resulted in a hiring spree of physics PhD’s....
"Pish. Posh." is a technical term only used by market professionals for those situations where one has decided to go full Alinsky rule #5*
*#5 Ridicule is man’s most potent weapon. It’s hard to counterattack ridicule, and it infuriates the opposition, which then reacts to your advantage...

The Convexity Maven is nothing if not a professional. Here is part of his mini-bio at MacroVoices:

Harley S. Bassman
Harley Bassman created, marketed and traded a wide variety of derivative and structured products during his twenty-six-year career at Merrill Lynch.  In 1985 he created the OPOSSMS mortgage options product that facilitated risk transmission between MBS originators and financial institutions.  In 1988, he assumed responsibility for trading and marketing IO/PO and other levered prepayment securities.  Soon after this, he started purchasing RTC auctioned MBS Servicing rights and repackaged them for the securities market as BIGS - Beneficial Interests in GNMA Servicing.  Later, he started a GNMA servicing conduit becoming one of the Top 20 originators in 1992.  As managing and hedging prepayment risk became a priority focus for the financial markets, Mr. Bassman created PRESERV, Merrill's trademarked Prepayment Cap product. Merrill was a leader in this product category writing protection that covered the risk on tens of billions of notional mortgage servicing rights.  Later, Mr. Bassman managed Merrill's initial venture into off-balance sheet mortgage trading.
In 1994, Mr. Bassman assumed responsibility for OTC bond options.

Within a year, Merrill was the leader in this product sector.  A wide variety of products were offered including vanilla and complex options on MBS spreads and the Treasury yield curve.
To help clients more fully appreciate Volatility as a primary risk vector, he created the MOVE Index.  Similar in form to the VIX Index, it is now the recognized standard measure of Interest Rate Volatility.

From 1995 to 2000 he focused on creating hedge strategies for MBS servicers and portfolio optimization techniques for Total Return and Index investors.

Mr. Bassman became the manager of North American MBS and Structured Finance trading in 2001.  During his tenure, he created SURF, (Specialty Underwriting and Residential Finance), a self-contained Sub-Prime mortgage conduit.  He supervised the issuance of Merrill’s first Sub-Prime securities. He also transitioned the structuring business to a new technology platform....
And so much more, all those cutesy Merrill acronyms can be blamed on him and his team. 

I've been debating whether to post this as much of the early material is basic/intermediate stuff (you should see Harley when he gets going on more advanced tactics, a tour de force in every paragraph!) but in this short little monograph he just keeps building and building and we get to watch someone who is the master of his material, much less of his domain.

note for newer readers: when he refers to the MOVE index, his invention while at Merrill, he is talking about a sentiment indicator for bonds akin to the CBOE's VIX for the S&P 500. Both are derived from prices of options on the underlying
Convexity Maven: "Moral Hazard" (see also Long Island)