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:

http://moveyourmoney.info/

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