Tuesday, October 25, 2011

Negative convexity in mortgage bonds

I love it when the real world behaves in just the way that I wrote on the class room white board!

Case in point: Mortgage bonds have negative convexity over certain ranges of interest rates.  This means that when rates fall the value of the bond falls instead of increases as would be the case for a typical bond.  The reason for this effect is refinancing by the homeowners whose mortgages make up the cash flows of the bond.  As these homeowners refinance, the amount of promised cash flows declines, and so does the value of the bond.   Interest rates matter here because lower interest rates result in more refinancing.

OK, so what is happening today?  Well, there are a lot of homeowners who can't refinance because they have negative equity.  So even though they see interest rates fall, they cannot take advantage of these lower rates, that is, until now.  President Obama's latest initiative to enable these under water homeowners to refinance will result in many mortgage bonds getting paid off early and, as a result, fall in value.

The FT has a great article on this which notes that only the mortgage bonds which had coupon rates that are above the prevailing mortgage interest rates suffered a price decline around the announcement of the plan - exactly as we would expect.

As noted in the article, part of this plan is basically paid for by a wealth transfer from the mortgage bond holders to households.