Mortgage Hedging and Interest Rate Risk

By Mike Marshall

Last year, I wrote an article on how to hedge an adjustable rate mortgage (ARM) with futures products. Due to a strong interest in this topic, I am revisiting this strategy to reflect today’s market movements and risks.

As I mentioned back then, the seemingly obvious outcome of the credit crisis would leave many homeowners underwater on adjustable rate mortgages and thus unable to refinance. Unfortunately, this prediction has become a reality for many.

With interest rates at the lowest levels we have seen in many years, the desire for individual homeowners to refinance into a fixed rate mortgage is a dominant theme these days. While the banks are aware of this and will certainly push this idea to generate fees and new loan activity, the credit crisis has left many banks undercapitalized and nervous, making it harder for homeowners to refinance their ARM loans.

Interest Rate Risk

The danger out there for many homeowners and investors alike is and will be interest- rate risk—the risk the interest rate will increase. If you are a banker who is concerned that interest rates are going higher, your incentive to issue new fixed rate loans at today’s low rates is relatively low. Sadly, this concern will only exacerbate the problem. The Federal Reserve is well aware of the danger of higher interest rates and will keep short-term rates next to zero for as long possible. Yet, the Fed’s ability to control long-term interest rates, and most importantly, the rates banks will charge consumers, is modest at best.

What the Fed has done, and will likely continue to do for the near-term, has been to allow banks to borrow money at very low short-term rates. Banks should be passing that on the consumer, but are unwilling to because of the fear of rising loan defaults.

The Fed has also been artificially keeping long-term rates low by buy long-term debt from the Treasury. (I will say this again in case you didn’t get it!)  The Fed is actually buying U.S. Treasury  two-year, five-year, seven-year and 10-year notes and 30-year bonds to artificially keep rates low. This has been going on for some time, and in fact has been done in the past for the sake of the interest rate market. When there is a lack of bidders, i.e. a lack of interest in tying up your money for any period of time at today’s low rates of return, the interest payments on the notes and bonds must rise to attract investors. Instead of letting the interest rate markets find their own equilibrium, the Fed is printing money and using it to buy U.S. debt; creating the remaining demand needed to keep rates low.

Eventually, the Fed will slow its purchasing of this debt and rates will begin to move higher. Sadly, low interest rates and rampant printing of money is typically a recipe for disastrous inflation and I think it will eventually force the Fed to raise interest rates to cap it. In my view, the only reason we haven’t seen this inflation come to bear as of yet is due the massive loss of equity from the housing market fallout.

The banks are well aware of the current risks, and that is why refinancing to fixed-rate mortgages has become much more difficult for the average homeowner. The incentive for banks to issue new fixed-rate loans is diminishing with time. With many ARM loans scheduled to reset in the coming months and ever-increasing unemployment as catalysts, the scenario could easily look something like this:

Inability to refinance will lead to fewer new loans and fewer home purchases, which will lead home prices to head yet lower still. The loss of home equity will lead more homeowners to go further underwater on their existing mortgages, which will lead to higher defaults and cause the banks to charge higher rates for the increased risk of issuing a new loan.

It is easy to see how this scenario could quickly snowball out of control and send interest rates soaring. I think the power of the Fed to influence interest rates is quickly waning and the time to act is now. If you cannot refinance to fixed-rate mortgage, you will be subject to interest -rate risk over the next several years. Similarly, if you own bonds or notes in your portfolio, increasing interest rates will mean you could be missing out on money you could be making at those higher rates. The alternative is to use a hedge in the interest rate futures products as a way to profit from an increase in interest rates.

Selling Eurodollar Futures to Hedge an Adjustable Rate Mortgage

From my studies, the Eurodollar futures market appears to be the best product for accomplishing the hedge. The Eurodollar futures contracts are an index based of 100 — LIBOR.  (LIBOR = 1 percent, Eurodollar = 99.00)  Since many adjustable rate mortgages are based off the LIBOR (the London Interbank Offered Rate), this becomes an ideal hedge for and ARM loan. As ARM loans rates go higher, so too will the LIBOR, thus pushing the Eurodollar market lower. Each 1 percent move on the LIBOR equates to a 1 point-move on the Eurodollar futures. Each one-point move in the Eurodollars yields $2,500 per contract. A 1 percent change in interest on a $250,000 loan would also be a $2,500 difference.

The advantage of using the Eurodollar futures market not only lies with the previously mentioned reasons, but also with the highly liquid contacts several months and even years out into the future. Getting the time frame right is the key to making this hedge effective. If you sell December 2009 futures, it is unlikely you will get much benefit as rates may not change very much between now and the end of this year. However, if you sell December 2010 futures, you can essentially “lock in” today’s rate expectations through the rest of 2010.  Liquidity begins to dry up after around December 2011 in the Eurodollar market, so some rolling on contracts will be order as time progresses.

Executing the Trade

Since the Eurodollar is an actively traded market like any other, it will price in interest rate increases long before they occur in the real world. The danger I see for a homeowner with an ARM loan is not taking any action in today’s environment of artificially suppressed interest rates.

Obviously each individual has their own risk tolerance levels. Because of this I have looked at several ways to accomplish this hedge. You may want to sell Eurodollar futures contracts outright, or you may prefer to buy put options if you prefer defined risk.  You can also accomplish this hedge with calendar spreads, buying front month contracts and selling back months. Each strategy comes with own unique risk and reward parameters and you should understand exactly what the risks are before entering any trade.  The flexibility of the futures and options markets allow me the ability to tailor a strategy to meet each individual’s needs and tolerance for risk.

I welcome the opportunity to speak with you further about this topic or any other questions you may have about the markets.

Mike Marshall is a Market Strategist with Lind Plus, Lind-Waldock’s broker-assisted division. He can be reached directly at 800-437-4189 or via email at mmarshall@lind-waldock.com .

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