When Salomon Inc. announced on Mar. 4 it had lost $250 million from trading, rivals wondered how such an astute dealer could get hit so hard--with rates falling and bonds surging. "What in God's name could you do in two months to lose a quarter billion?" said one.
These days, it doesn't take much. Salomon is just the latest to suffer the effects of volatile, newfangled products in the capital markets. These markets have always been volatile, and big Wall Street firms have made and lost fortunes. What is different now is the emergence of highly complex securities, many relatedto mortgages, whose prices change faster than bond prices--and at varying rates of speed.
Other savvy securities dealers such as J.P. Morgan & Co. have lost at least $100 million trading these securities, according to analysts, and rumors are flying as to which banks and firms will show bruises from securities price swings in the first quarter of 1993. Some experts say it's beginning to look as if a number of banks and securities brokers are routinely erring in how they hedge themselves against the new instruments.
DELUGE. The recent free-fall in interest rates has been a boon to many bond traders, but not to those in most mortgage-backed securities. Homeowners and home buyers have been jamming the phones at banks and mortgage companies, eager to lock in low mortgage rates by refinancing. And when people pay off old mortgages, the securities that were backed by those mortgages mature unexpectedly fast, so the yields on many such mortgage-backed securities drop like a stone.
It gets worse in the market for mortgage-backed derivatives known as interest-only (IO) mortgage strips. IOs are created when a mortgage-backed security is divided into two pieces: The interest payments constitute an IO, and the principal payments constitute a principal-only (PO) security. Holders of an IO get nothing more than a stream of interest payments--a stream that can continue for years if interest rates remain high and if few homeowners refinance their mortgages--but one that can quickly diminish to a trickle when rates fall and mortgages are being refinanced.
Dealers like the high yields on IOs. And in the past, they could usually hedge their positions enough--by buying Treasuries, for example--to profit from the yield and yet remain protected against moderate price drops. But the market has been anything but moderate lately, and when rates fall sharply, the hedges stop working (chart). When long-term rates fell in January and February, for example, prices on IOs plummeted 34%. The price of a 10-year Treasury rose about 6% over the same period--hardly an adequate hedge unless one bought so many Treasuries that the cost of hedging became prohibitive. "You can really get whipsawed with those babies," says Hollis W. Rademacher, treasurer of Continental Bank Corp.
Salomon appears to have learned about the volatility in the IO market the hard way. The firm is a big proprietary trader, trading heavily for its own account. The firm won't comment on the source of its trading problems, but competitors say Salomon is known as a major buyer of IOs, and it appears to have had a position in IOs that was not adequately hedged by a position in Treasury securities.
OFF BALANCE. J.P. Morgan's 1992 trading losses in mortgage-backed securities seem to be IO-related as well. A spokesman for the firm would say only that "the mortgage prepayments have given all sorts of fits to dealers" and declined to discuss the specifics of Morgan's losses. But sources familiar with the bank's trading believe that Morgan bought IOs to finance interest payments the bank had promised to buyers of a new investment product.
Somehow, sources say, rapid price moves in the IO market rendered Morgan's IO hedge inadequate, and when the price of IOs plummeted in the first quarter, the bank took a hit. Morgan lost upwards of $50 million in the mortgage-backed market in the first quarter of last year, and it followed that with additional losses through the year. Those losses helped drop Morgan's 1992 trading revenue to $959 million, from $1.3 billion in 1991. The losses are a short-term embarrassment for both firms, but Morgan and Salomon may have gotten off easy--provided they've since gotten out of the IO market. Experts say some firms that trade IOs could have it worse in the coming weeks, because the full impact of the latest wave of mortgage refinancing isn't yet reflected in IO prices. Refinancing applications have hit record levels on several occasions during the past year, but the line is so long that many actual refinancings have yet to take place. Worse, refinancing activity tends to increase when rates take a turn upward. One mortgage banker recalls that, when bond prices sagged recently, "the phones went crazy."
To be sure, securities firms and banks make serious attempts to hedge their positions in volatile markets. They are spending millions on the latest technology to develop models that will help them navigate the markets, and many banks have made risk-management specialists into senior officers. Several firms have also lured the giants of financial theory from America's top universities to help them build these models.
GARBAGE IN? Experts say the models that securities dealers and banks are using aren't set up to deal with today's market conditions, though. In the case of mortgage-backed securities, they note, the models are failing to predict how quickly people are refinancing their debt. "The models are fine, given the right volatility assumptions," says Andrew S. Carron, a director at First Boston Corp. But "there's no way of knowing for certain that you've put in the right assumptions."
Many models, for example, predict that homeowners will replace 30-year adjustable-rate mortgages with 30-year fixed-rate ones. In reality, though,thousands of people are switching into 15-year mortgages. That means that pools of mortgages backing mortgage-backed securities are changing more dramatically than the models indicated they would.
"Risk managers at brokerage firms talk about being [hedged enough to protect themselves if prices move] two standard deviations from the norm," says Stephen Robert, chairman of Oppenheimer & Co. "However, it's the third standard deviation that happens once in a blue moon--that's what kills you."
Few dealers are prepared to stop trading in volatile markets. The potential returns are simply too alluring. But with rapid price swings increasingly common, these dealers may now realize that even the fanciest models can't protect them from today's roller-coaster markets.