From the September/October 2012 issue of Treasury & Risk magazine

Gold AHA Winner in Financial Risk Management

Hedging Against an Economic Upturn: Google

Hui-Chien Chang, director of the portfolio management group Hui-Chien Chang, director of the portfolio management group
Many risk managers try to prepare for things going wrong. Google tackled the problem of protecting itself if things go right—if the global economy turns around and interest rates head higher. The company had invested in agency mortgage-backed securities (MBS) because of the relatively attractive yields (1.5%-2%) and if rates rise, it was looking at a potentially large drop in the value of those investments.  

“When the Fed raised the overnight borrowing rate from 3% to 5.5% in 1994,” notes Hui-Chien Chang, director of the portfolio management group, “the Barclays’ U.S. aggregate bond index had a dismal return of -2.94%.” That was not the kind of loss Google could accept.

Like any fixed-income security, MBS prices move inversely to interest rates, so rising rates depress prices. Agency mortgage-backeds have little perceived credit risk because they are issued by agencies of the U.S. government, but they have prepayment risk. The securities are backed by home mortgages and homeowners can pay off their mortgages at any time, so the duration is not fixed. Higher rates would discourage prepayments, lengthening the duration of the securities and making their price drop even more. Google needed a hedging strategy and an appropriate hedging instrument.

While this approach creates good economic hedges, they don’t qualify for hedge accounting treatment, Agrawal explains.  As a result, the mark-to-market value change of the TBA hedges flows through the income statement without any offset from the changes in the underlying MBS portfolio, which are recorded on the balance sheet. Thus, a key constraint is “to manage the risk of the hedging program and control the accounting mark-to-market volatility associated with it,” he says.

Google also hedges by selling forward specified pools of mortgages that are revealed to the buyer before the sale. Because specified pools are usually of better quality than pools delivered to settle TBA contracts, they are priced at a premium over TBA prices, Chang says.

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