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Option Adjusted Duration and the VIX: Are You Really Hedged?
First, if you have not heard about the grass roots movement started over the holiday by Ariana Huffington and Rob Johnson to encourage Americans to move their money out of the big banks into solvent regional banks, community banks and credit unions, click the link below. IRA has contributed one of our web services widgets to make the site's bank lookup funtionality:
We are not being paid for the use of this tool, which let's you look up banks by zip code that have at least a "B" or better rating on the IRA Bank Stress Index. We cut off the banks > $65b in total assets. Sorry NTRS (which is an "A+", BTW).
Now for the main course. Watching the VIX hit a 16-month low, I am beginning to believe that Uncle Ben and the other members of the FOMC have created a 1980s style interest rate trap for banks and other leveraged fixed income investors via the Fed's asset purchase program.
Why?
Because the Fed's purchases of $2 trillion in MBS and Treasuries has suppressed visibility market volatility. That is, option-adjusted spreads (OAS) on MBS are currently negative -- if you adjust for the Fed's intervention.
That's right. Whereas the GSEs sell the optionality when they buy MBS, the Fed did not, so the net effect of the buy was to hand Bill Gross at PIMCO, Blackrock and the other Buy and Sell side firms a free 100bp profit, but take the entire Street short volatility -- involuntarily. BTW, Bill's latest comment includes a clear admission of his firm's sales to the Fed.
Everyone thinks of the equity markets when the effects of the latest Fed intervention are considered, and correctly so, but think about that fixed income risk manager or bank treasurer who believes he or she is hedged given current levels of volatility vs. the MBS book. In fact, the OAS on MBS is negative, but most bankers don't realize this because the VIX says that volatility is low.
Why does this matter? Well, to paraphrase my friend Alan Boyce:
- VIX is depressed because the Fed is shorting interest rate volatility.
- All volatility markets are correlated. Volatility itself is correlated to the slope of the curve AND interest rates.
- When the curve steepens, volatility will get pulled up.....and visa versa.
- When volatility goes up, option-adjusted durations (OADs) extend.
- When the curve steepens, OADs extend.
- When interest rates rise, OADs extend.
Based on my conversations over the past two months, I am pretty sure that nobody on the FOMC with voting authority understand the huge interest rate risk that now faces banks and other leveraged investors in debt. All debt. Indeed, everyone who uses ersatz market "indicators" like the VIX is underhedged -- except the mortgage servicers. The servicers are fully hedged with constant maturity mortgage (CMM) swaps, which will extend massively when rates (curve or volatility) rise. Then the mortgage servicers will become SELLERS of duration.
Got it?
So when you go into the risk committee meeting next week, look across the table at your CRO/Treasurer and ask him/her where they think the VIX would be today were it not for the Fed's asset purchases. Somewhere between today's 16-month low for the VIX and that theoretical volatility is where you really want to be. -- Chris
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RC,
I always enjoy your work and your TV appearances. You have a particular gift as a verbal communicator, possessing the ability to make complex matters easily understandable.
I have an idea to help balance the Federal budget: C-SPAN could run a Pay-Per-View where Chris Whalen gets a few hours to interview Ben Bernanke and Tim Geithner---under oath---at a Congressional Hearing.
Thanks for the comments. Couple of thoughts.
1) Yes, MBS is tough. The securities are a series of prepayment options and there really is no way to predict prepayment. Street has been trying for 30 years. It is, to paraphrase Hayek, a function of "human action." My pals at Bear, Stearns used to use zip codes to trade specified pools. Like looking for land mines with a golf club.
2) On "move your money: going viral, oh yeah. We've logged search requests for half of the zip codes in the US since 12/30/09. Took our site traffic up 10 fold. You can read the update by my business partner Dennis Santiago on Huffington Post: http://www.huffingtonpost.com/dennis-santiago/d7-shock-and-awe_b_412681.html
Yeah, there are companies like ADCo that make their money creating models to predict prepayments.
But Bernanke buys 1.25T of them with no one at the Fed with any experience trading them. There was a story a couple months ago about the dude who was in charge of the operations, the guy was from academia.
And TD posted a job posting from the Fed for MBS experience - 5 months and 500B after they started buying.
So you give money to Blackrock to buy you some MBS with no instructions except to buy, price be damned - so they literally set the same bid for months, regardless of where the curve was. Look at the history of mtgefncl - 4s were bought at par for almost 3 months. Crazy.
I guess when you can print money, price is not an issue.
thanks for another excellent piece, Mr. Whalen, sir.
cannot wait to watch all the chartists w/o nuance point to simple crap like 2/20 standard deviation outside day equity buy signals in a few months; just like last fall.
and options market makers thought they were pissed last fall ?
haha ... equity option spreads gonna get blown THE F out like cindy lauper's doo.
hello triple-digit all-time-high VIX / VXN / VXO. oh, what's that, you're not due for another 11 / 13 months, just letting us all know in advance. well, thanks for the heads up; cya real soon.
Always a pleasure to see your views on ZH Chris.
I've followed "moveyourmoney" very closely and I suspect the counter pressure on your group and Arianna is going to be enormous, likely quite ugly. I'm hoping that Arianna will openly discuss the repercussions on HuffPo and I really hope that you will provide feedback on the crap that you are about to receive from the powers that be. I can see Sheila Bair making a call and reciting chapter and verse about the law governing the encouragement of runs on banks........ if she calls you in for a meeting, please remind her to use a really good black magic marker to cross out your visit for the next FOIA request of her schedule. Still waiting to hear from you on that one, Meredith dear.....
The TBTFs (except GS, MS for obvious reasons) get very, very touchy when there is any threat to their core deposits. Add to that the fact that the loss of the core deposit usually translates to total customer loss (except loan products if the customer can't re-write at the new institution) and kills cross sell ratios, wallet share metrics and, ultimately, profitability.
I spent years in retail banking and had a very successful career and you know why it was successful? I was a customer service freak....I enjoyed the people, genuinely liked helping them with their banking, always told them the "fine print, bad news" information FIRST, which was universally appreciated as they were adults, not dummies. People always thought i was a great salesperson but the truth is that I simply listened to their needs, treated them royally, told them the truth whether it was what they wanted to hear or not, never hustled them to make a sale and because of that, they always came back when they had the need. I was not the smartest guy in the world but I did recognize that nothing is more important than the customer and it is from the customer that all profit flows.
The large banks have screwed over their customers and those folks are pissed. In the longer term, this alienation of the customer will be the number one reason for their demise, moreso than the chicanery of FASB 157 or toxic assets or rate whoring or fee jacking.
Deadhead, that was a great read! It is so enjoyable to find out that somewhere, someplace, there is not a dirt-bag in the business.
Thank you, rc whalen, for this peek behind the curtain...for excellent analysis.
Makes me wonder if this is a black swan hatching.
Can anyone suggest how a small-time investor can protect themselves, or better, make money if and when the VIX snaps up?
VXX VXZ are an easy way to do that.
Thanks, YY.
I'd recommend reading this before you put any money in VXX.
http://vixandmore.blogspot.com/2009/10/why-vxx-is-not-good-short-term-or...
Oops. Hit the return key too many times. Anyone know if there is there a way to delete duplicate messages? All I can do is edit; can't find a way to delete message. Sorry for duplicate messages.
Oops. I hit the return key too many times.
Thanks, Green Sharts. I appreciate the helpful information.
Thanks, Green Sharts. I appreciate the helpful information..
VIX is clearly underpriced, it will turn out to be a wonderful opportunity. We still live in a harsh world from geopolitical to financial manipulations, only an idiot would expect lower VIX going foreward, and I sure will be a buyer.
"Then the services will become SELLERS of duration."
Oh, and what does this mean? Are you trying to say when rates rise, servicers will sell rates, leading to more upward pressure on rates, like a negative feedback loop?
Uh oh.
"That is, option-adjusted spreads (OAS) on MBS are currently negative -- if you adjust for the Fed's intervention."
You mean a spread of mtgefncl to gt10 of 66bps doesn't compensate for the negative convexity of mortgages? hoocoodanode??? So THAT's whay spreads are usually 130-150bps.
Man, this MBS stuff is tough, maybe we should just stick to buying Treasuries.
Lmao...+100