Consulting Corner

Qualifying the Performance of Leveraged MBS Strategies
By Mickey Storms

Leveraged MBS investors have endured some fairly unpleasant surprises over the past several years. The sudden and poor performance of various small, privately managed hedge funds as well as a large government agency or two, highlights the ongoing difficulties MBS investors face in monitoring the risk and prospective performance of complex and leveraged MBS portfolios. Investors in leveraged MBS strategies are less likely to experience surprising and negative returns in instances where they scrutinize and quantify the following:

• The risks to capital as measured by the potential change in the difference between the value of assets, liabilities and hedges.
• The hedge fund capitalization or leverage as measured by the ratio of assets to equity.
• The expected net spread as measured by the spread between assets and liabilities after hedge costs.

The information in the table below can be used to help rationalize the returns proffered by leveraged MBS strategies in terms of the risk aspects highlighted. The first three columns describe the relevant range of leverage and capital applied in various MBS strategies. The relevant range of hedged net spread (OAS) is presented along the top of the table. The ROE resulting from various leverage and hedged return combinations are presented in the center of the table. The gray area in the table highlights combinations of risk and return that generate an ROE between 10% and 20%, frequently targeted by leveraged MBS managers. >>>