“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.