Bond rally nearing an end?

Quote from mcurto:

Still not covering the put position. I have a strange feeling it could have been Countrywide or even PIMCO protecting some long mortgage position (rather than in-house Goldman) but again who knows. All that matters is the mortgage markets have ZERO sponsorship right now and this is just exaggerating the massive move lower in Treasuries. With the spread product widening everyone looks to sell something against so Treasuries and/or swaps are the two most liquid options at this point in time. When you push one domino, in this case 5% in the 10yr cash, the rest of the dominos fall hard and fast. In terms of flows I have heard the mortgage-related selling is starting to slow but there is probably a point where it gets triggered again.
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I find this fascinating. Is it possible you could quickly explain in concrete (and hopefully simplified) terms how a long MBS position holder would hedge with short treasuries or 30 yrs ?? I am curious also how prepayment risk of MBS's factors into this, since long MBS longs are essentially short the 'prepayment call' to the mortgage holding end user. Any way to simplify an explanation with details of likely hedge ratios ie...

a. PIMCO owns 20B worth of MBS. assumption: PIMCO wants to hedge downside risk in this high foreclosure market.

b. therefore if yield drops to predetermined hedge points, they sell treasuries to protect principal on portfolio. They sell ie 10B notional worth of treasuries for every 50bps yields rise above ie 5.0 percent.

c. how is prepayment call dealt with? what does the MBS holder hedge with as call exercise risk increases? do they simply buy puts on the open market when MBS's fall to strike points?
etc. etc.

Is it safe to assume MBS hedging is much like any short vol position works? ie buying more as something goes higher, selling more as something goes lower ?
 
You hit the nail on the head with the last point. Owning mortgages you are implicitly short volatility. Normally your risk is a bit more on the upside but with the massive swap spread widening down at these levels they are forced to hedge just as much if not more.
 
Any thoughts on who was buying notes in size on the retail sales? It was pretty chunky and aggressive buying down there...

Can't remember who but there was a well large buyer of 104 puts a number of weeks ago, seps or decs, who may have been interested in buying in size against these
 
Quote from mcurto:

You hit the nail on the head with the last point. Owning mortgages you are implicitly short volatility. Normally your risk is a bit more on the upside but with the massive swap spread widening down at these levels they are forced to hedge just as much if not more.
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ok. good i'm on the right track.. is it possible you could outline an example of an MBS hedge occurring with specific products?
 
Countrywide is starting to buy the Sep 102 puts in the 10yr options to protect against spread widening if we were to break lower again. That is the most obvious one I can think of at the moment.
 
The more I thought about the Goldman put position my guess is it was probably a front-run on all of this mortgage hedging and the fact that Countrywide would eventually need them (giving them an out down the road besides liquidating with locals who wouldn't let them out at favorable prices). You can't tell me that they wouldn't have heard of these possible flows with their massive customer base. And they got a great deal on those puts because volatility hadn't gone bid yet.
 
agreed...Goldman doesn't trade at $228 a share by making big mistakes....

although the Central Bank of China could have fired a shot across the bow to say that they control rates, not Uncle Ben
 
Swap futures trade by appointment for the most part. There is almost always a 15,000 lot roll between Goldman and JP Morgan for the 10yr swap futures every quarter. I am sure these positions both have 10yr Treasury futures on the opposite side. There is very little intraday liquidity for swap futures (doesn't trade more than a few thousand a day) but definitely decent enough open interest for the big boys to put on spread plays against Treasuries.
 
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