Under pressure

Interest rate swaps

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Life has been pretty tricky for traders in the US interest rate swaps market in recent weeks. Large mortgage-related hedging flows, dealer hedging of constant maturity swap (CMS) spread-linked structures, systemic risk fears, and the apparent repercussions of a dramatic fall in pricing among certain structured credit indexes have, at times, put the market under some stress.

Swaps spreads have moved erratically on several occasions since late last year. On December 7, the 10-year dollar swap rate widened by 2.5 basis points - a five-standard-deviation event on what, given the fundamentals, should have been a day of minimal market activity. Some analysts have claimed the most plausible explanation for this shift was dealer hedging of mortgage-related exposures. The catalyst was the collapse that day of California-based subprime lender Ownit, prompting fears that this could be the first in a wave of subprime lender failures.

Dealers say they witnessed some sizeable and, at times, panicked hedging activity by mortgage banks in January. "There was a significant lengthening of mortgage durations in the seven-week period from early December 2006 to late January, as positive economic data caused the market to take out its expectation for any near-term cut in interest rates," says Terry Belton, head of the New York-based US fixed-income strategy team at JP Morgan. "This prompted one of the heaviest periods of swaps hedging activity of the last year or so as mortgage banks rebalanced their hedges."

According to research by Belton's team, mortgage banks have, in aggregate, needed to hedge with around $40 billion-50 billion of fixed-payer swaps in 10-year equivalents for two months in a row. It appears that the major mortgage banks may have been under-hedged (see box).

Beyond the more familiar hedging needs of mortgage banks managing the convexity risk arising from being short a prepayment option to borrowers, exotics-related hedging has also been prominent. In particular, the hedging of CMS spread option products has had a palpable effect on the market, and certain segments of the swaps curve have now become technically driven, says Mark Taylor, a senior exotics trader in the interest rate derivatives group at RBS Greenwich Capital in Connecticut. "It's now apparent that as soon as the two-year to 10-year or five year to 30-year parts of the swap curve move by 1 basis point or so, traders rush in to put on positions that, in effect, push the curve back the other way," he says. "The curve is not being allowed to move very much."

Others agree. Eric Liverance, head of derivatives strategy in the fixed-income research team at UBS in Connecticut, says it's remarkable quite how flat the portion of the curve between the two-year and the 10-year swaps rates (referred to as 10s/2s) has been since December last year. "The curve hasn't really stayed flat for so long - hedging by exotics desks is exerting a pressure on the curve that is keeping it flat," he says. For the period from the start of 2003 to the end of 2006, the average spread on the 10s/2s portion of the swap curve was 127bp. From the start of this year until February 26, this spread generally traded in a tight range of between zero and 5bp. The spread was at 7.25bp at the end of trading on February 27 - a day when many markets across asset classes endured dramatic drops and volatility.

The structure with which much of this hedging is associated is the so-called non-inversion note. These range accrual products allow investors to profit handsomely while a specified part of the CMS curve - for instance, between the two-year and 10-year points - is non-inverted. The risk profile of these structures is such that during periods of flattening, but non-inversion, dealers have to put on swaps curve steepener trades (where the dealer receives a payout based on the spread between two swaps rates as a hedge). The effect of the steepener trades, when put on en masse by dealers, is to counter the dynamics of the swaps curve; in other words, without the steepener trades the curve may well have continued to flatten and flatten, and then invert.

A consensus has now emerged among the major interest rate derivatives houses that dynamic hedging by dealers of CMS spread-linked structures is contributing to the flat swaps curve - an assumption that was considered somewhat controversial just a few months ago (Risk December 2006, pages 36-38).

Another, somewhat contentious, market dynamic has also been posited by some to exist in the US interest rate swaps market. A research note lead-written by Priya Misra and James Ma, swaps strategists in the fixed-income research team at Lehman Brothers in New York, hypothesised that a widening in 10-year swap spreads from around 48bp in mid-January to more than than 52bp as of February 26 was indirectly related to the dramatic widening of two sub-indexes of the ABX.HE - a structured credit index of US subprime home equity asset-backed securities (ABSs).

"There does appear to have been some idiosyncratic swap spread volatility associated with the ABX credit-related issues in the subprime mortgage market," says Ben Martens, a colleague of Misra and Ma's at Lehman Brothers whose research focuses on interest rate volatility.

At first glance, the claim that ABX.HE, and in particular the ABX.HE. 07-1 BBB- index, the spread of which widened dramatically from just under 700bp at the start of February to more than 1,500bp by the end of the month, has somehow become a driver of swaps spread dynamics seems a little strange. After all, the BBB and BBB- 2006 and 2007 sub-indexes saw most of the widening, and there is no obvious fundamental reason for this subprime weakness to directly affect swaps spreads.

Magnitude

Dealer hedging of subprime ABS inventory isn't the mechanism at play - subprime ABS and ABS collateralised debt obligations are mostly floating-rate products. And while ABX.HE spread widening has become correlated with swap spread widening since the start of February, the magnitude of the widening of the former relative to the latter is very large (see figure 1). So, if the underlying cause of the increased correlation in spreads between the two markets was the hedging of ABX.HE spread widening with interest rate swaps, this would require extremely large hedging volumes, which doesn't appear to be practical or, indeed, desirable from a cost perspective.

Instead, Lehman's Martens gives a more indirect explanation of the apparent influence of ABX.HE spread widening on interest rate swap spreads. "Where it can, and apparently has on certain days, affected swaps is when the market becomes risk-averse," he says. "There is a fear that what is going on in the lowest tranches of the subprime market will somehow affect the broader credit market."

So, how might this kind of market contagion actually come to pass? One popularly recounted hypothetical scenario among those who believe a slowdown in the US housing market may lead to a recession goes something like this: defaults on subprime mortgages grow to such a level that there's a surge in foreclosures and this drags down home price appreciation across the US. "This is one way that trouble could spread from low-quality to high-quality credit," says Martens.

But then how might the contagion spread to the swaps market? If the value of dealer inventories of higher-rated mortgage-related products starts to take a hammering, these firms will probably pile into the swaps market to rebalance their fixed-rate payer swap hedges. "It's an indirect effect, but it could certainly prompt swap spreads to move out," says Martens. Consequently, dealers and other investors in mortgage-related products may currently be putting on fixed-rate payer swaps to position themselves defensively for any potential credit market contagion.

In fact, in the last week of February, jitters over rising delinquencies in the subprime mortgage sector contributed to a widening of spreads in the broader credit market. On February 27, the Dow Jones CDX Crossover index closed at 146bp, up 32bp from the previous night's close.

Swaps traders and analysts are keeping a close eye on the potential for further contagion spreading out from the ABX.HE index market. By the end of last month, even those traders who had been sceptical about the emerging contagion theory were hard-pressed to maintain that stance, even if they disagreed about the precise mechanism by which the ABX.HE index had influenced swap spreads.

SLOW SERVICE

Mortgage servicing rights are generated when a firm sells mortgages and retains servicing of the loans or enters into a contract to service the mortgages of a third party. Tentative statistical analysis by the New York-based US fixed-income strategy team at JP Morgan, led by Terry Belton, suggests mortgage servicers tend to under-hedge their duration risk and instead rely on increased loan origination during periods of falling interest rates as a natural risk offset.

The conclusion was arrived at by regressing aggregate quarterly servicing portfolio earnings for four of the largest US mortgage banks against changes in the 10-year Treasury yield.

Four of the largest mortgage servicing portfolios, belonging to firms whose level of disclosure in financial filings was adequate for the analysis to be meaningful, lost around $1 billion last year, including $239 million in the fourth quarter of 2006 (see table A).

A natural corollary of the analysis is that mortgage servicers, in aggregate, hedge around three-quarters of the optionality on their books. These hedges are executed either through swaptions trades or synthetic replication of swaptions via dynamic hedging with swaps, or a combination of the two.

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