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.

The simple framework applied in the table allows investors to focus on whether the risk and leverage utilized in a given strategy and the hedged returns available in the market achieve the expected ROE and whether the stated returns are consistent with the true risk of the strategy and the hedged returns available in the market. As important, the framework allows investors to see how ROE can be distorted by unrealistic assessments of risk, leverage, and hedged returns.

Example
The appropriateness of the risk and leverage utilized within a given leveraged strategy can be analyzed by applying statistical processes to historical price data. One example of assessing capital at risk statistically is to regress the historical monthly TRR of a FNMA Current Coupon MBS Index on the historical monthly TRR of the Agency Master Index. The magnitude and frequency of the forecast errors can be used to formulate the net capital risk inherent in a strategy that features a long 30-year FNMA current coupon MBS position funded by a duration equivalent portfolio of Agency liabilities.

In this example, the ordered forecast errors show that the FN 30-year current coupon MBS TRR can be less than expected on a duration neutral basis by as much as 3.53%. For this leveraged MBS strategy using a level of capital of less 3.53% could imperil the solvency of the strategy.

The 3.53% level of risk relates to an interpolated leverage ratio of 28 to 1. Moving across the first table it can be seen that hedged returns below 30 OAS would fail to generate a TRR above the minimum 10% level. Consequently, if the assets, liabilities and hedges utilized in such a strategy conformed to expectations and OAS levels were 30 basis points or less, yet published returns were much higher than 10%, investors might question whether the true leverage being utilized is in excess of 28 to 1. Likewise, if the leverage used in this strategy was known to be 28 to 1 and OAS were known to be less than 30 basis points while published returns were notably higher than 10%, investors should begin to question whether the assets, liabilities and hedges conform to expectations, and whether valuations are correct.