Mortgage Convexity Risk

Fixed-Income Research

Mortgage Convexity Risk

June 30, 2003 MBS Strategies Srinivas Modukuri 212-526-8311 modukuri@lehman.com Vikas Reddy vshilpie@lehman.com David Rashty drashty@lehman.com Marianna Fassinotti mfassino@lehman.com Mortgage convexity risk is a topic which has received much attention from both mortgage as well as non-mortgage players. With a steady increase in the size of the mortgage asset class as well as increased consolidation of this risk in the hands of active hedgers, the duration rebalancing and volatility needs of these players has had a significant impact on the overall fixed income markets. Until now, the most pronounced period of mortgage hedging related flows was in late ’00/early ’01 when the markets witnessed secular spread tightening and spread curve flattening due to a strong need to receive fixed in long swaps. In the current environment, the question that is on many investors’ minds is, what happens to the mortgage market in a selloff? The term extension risk has reached the popular press and there is a fair degree of speculation around the potential impact of mortgage hedging activity on the fixed income markets. In the following analysis, we examine the issue of mortgage convexity risk in more detail. Our analysis is structured as follows: First, we give a brief history of the impact of mortgage hedging activity and the reasons that have made it so pronounced in the past. Second, we take a detailed look at the factors that impact mortgage hedging flows – risk profile of the asset(s), proportion in the hands of active hedgers and prevalent hedging practices. After examining these factors in the current context, we present our outlook for mortgage convexity risk. To summarize: · The risks to the market are skewed towards the extension side and the magnitude is large. We expect the impact of mortgage hedging flows to become pronounced in a selloff and should manifest in the form of a secular spread widening, spread curve...