S Curve Postscript

OK, gang… here comes the first part of the ‘S’ curve, where the portfolio managers have to deal with potentially very fast prepayment.

Just when they adjust themselves for that, the extension risk (slow prepayment) comes rushing up into view, and the real question will be whether they try to hedge, sell and take losses, or try to ride it out with a combination of the two and low leverage.  (They all have much lower leverage today than they used in the bond rally / prepayment surge in the 2004-2005 time frame.)

There’s a good reason the mortgage departments used all the computers on the trading floor every night to try to calculate their risk across hundreds or thousands of potential future environments.

Unlike lots of other investments, MBS give you vastly different performance over a holding period if they go down and then up, up and then down, or just sit there.  All three end up at the same price, but the cash paid to the holder is vastly different.

It’s a lesson “quants” from equity land learn the hard way when they try to swim in the pond with the MBS alligators.



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