Q&A with Emily Hollis

Emily Hollis
May 28, 2008 | COMMENTS

Question: With the current state of the credit markets; are there opportunities in leverage strategies?

Most leverage trades are those that show a borrowing position and a reinvestment of those borrowed funds into an investment. These trades are generally done in an attempt to either enhance income or as risk reduction strategies (i.e. lengthening your liability duration). Last year, arbitraging into agency securities presented minimal income reward for spreads were tight. Things have changed.

Presently, the Federal Home Loan Banks and choice corporate credit unions across the country are offering credit unions fantastic borrowing rates in these low yielding environments. Now is the time to lock in borrowings to extend liability duration and reap the benefits of low funding rates once interest rates rise.

In doing so, be careful in your choice of borrowing structures. The lowest yields are those where the lender has the right to “call” away the loan should rates rise. The borrowings are there when you don't want them and when you do, they disappear. Another alternative might be to borrow against a floating index such as one or three month LIBOR with an embedded cap option. The “cap” would be the maximum rate to which the index of the floater could rise, i.e. a cap of 5 percent would equate to a maximum borrowing rate of 5 percent plus the spread or cost of the floater. Should rates move down by 1 percent, your borrowing costs would also fall by 1 percent, for the borrowing rate is based on that floating index.

If reducing risk is not your motive, leveraging strategies to enhance income are very common. Borrowing rates are historically low and mortgage spreads are historically high; therefore, the opportunity to generate income by conservative leverage strategies using agency mortgage securities is the best it has been in decades.

The most common arbitrage that we see from brokers is a callable borrowing leveraged into some form of mortgage-backed security. It is popular for the base spread is very wide. However, this trade intuitively does not make sense. When rates go up, the asset extends and the borrowing position is “called' away from you, leaving you exposed to borrow with higher funds. On the other hand, when rates move down and the asset goes away due to prepayments, the borrowing position extends, leaving you to have to reinvest at lower rates. The graph below says it all. You are exposed if rates move either way – up or down!



The most conservative arbitrage is placing a borrowing position that is comparable to the effective duration (price volatility) of your asset. The chart below shows a 3/1 hybrid MBS (same security used in the previous example) at a yield of 4.50 percent where the rate is fixed for three years and then commences floating at a spread to the one-year constant maturity Treasury. The borrowing is a three-year non “put” one year, where after one year the borrower has the right to put back the borrowing. Should interest rates rise, the borrowing will remain intact. Should rates fall, the borrower will “put” back the loan and borrow at a lower rate. As, you can see the “put” feature fits well with the prepayments of the mortgage loan should rates fall and vise versa should rates rise.



The difference in borrowing cost is 100 basis points (bps), with the putable at 3.75 percent and the callable at 2.75 percent. The chart below shows the income generated for a $500 million credit union conducting a $10 million trade using the putable borrowings. Spreads actually increase in the upward 300 bp scenario as the paydowns on the mortgage loans are reinvested in higher yields. Although base income is higher for the callable trade at 135 bps, in the up 300 bp scenarios, spreads decrease to under 30 bps.



Opportunities are out there. Borrowing has not been this “cheap” in a while. Credit unions that can afford to leverage should take advantage of this for eventually these spreads will narrow as the markets correct themselves.

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com. Margot Strong, director of business development, may be reached at mstrong@almfirst.com.