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Agency CMO PO Bonds Trading

By Udo Onwuachi, BA, MBA

Question:

My traders continue to overpay for PO bonds. Could you please let me know the
variables to use when pricing and trading a PO bond?
Answer:

There are different types of PO bonds, such as PAC, TAC, SC, SEQ, PT, STP SUP, PO
or Remics, etc.
You must take the following factors into consideration before submitting a bid or
asking for a PO bond:

• The uncertainty of loan payments due to poor documentation and human error;

• Proper hedging instrument;

• The number of hedging contracts that you need;

• Costs of hedging;

• Option;

• Past cash flow;

• Scaling up prepayment models vectoring out the PSA/CPR with emphasis on key
attributes, modified duration, effective duration, average life and convexity
using YB, Bloomberg or INTEX;

• Forecasting payments given inflation, mortgage services fees and loan balances;

• Is the collateral backed by GNMA, FNMA, FHLMC or a private label (whole loan
CMO)?
PO(A) PO(B) PO(C)

PSA: 90% Base 110%

CPN WAVG: 5.94 8.9 5.60

CPN SDEV: 0.12 0.10 0.11

MAT WAVG: 307 311 300


Figure 1:
PO (A) PO(B) PO(C)

Effective Duration: 11.4 20.0 10.50


The PO with 20.0 effective duration is the most volatile, so when you bid/ask you
need to know the correct OAS and the forward yields curve, as you can see from
Figure 1 above. The correct way to look at Figure 1 is that as a prop trader this
PO asset class will appreciate or lose 11 to 20% in the event of a 100bps in yield
change.
As a prop trader you want to shock the cash flow and duration; this gives you an
idea of where to bid. The goal is to avoid overpaying for a bond and to avoid
losing out on a bid.
PO(A) PO(B) PO(C)

Duration: 4.0 8.6 3.49


A prop trader should quantify the exposure of the prepayment models risk with
emphasis on the PSA if the deal is new and CPR if the deal is a seasoned one. Bear
in mind that major broker dealers have their own matrix; it is imperative that you
use public information in analyzing the price that you want to pay for a bond.
After all, Long Term Capital Management had its own matrix and the model failed.
The transparency and flexibility of your prepayment model should allow the trader
to modify the parameters to reflect your PSA/CPR expectations.
In trading agency CMO PO you should remember that the PO depreciates in a rising
rates environment and appreciates in a low rate environment. You goal is to be
able to tell when to bid either using OAS or forward yield curve. When bidding for
a new issue it is imperative to remember that the value of your PO will depreciate
due to amortization, and discount value factors because the original principle
decreases every month. I have priced over a thousand of PO (SUP, TAC, PT, STP,
PAC, SEQ and REMICS); these bonds are not all equal. Remember that the OAS is not
the be all and end all variable; other variables such as the effective duration,
LTV, FICO scores and geographic analysis are as vital.
The best thing for a hedge fund manager to do is to visit an underwriter with
his/her own coupon formula. Place an order instead of waiting for the underwriter
to sell you some PO nobody wants to buy, and then get a promise that the value of
your PO will not go down. I know and have seen structures that were extremely
profitable and remained so! The game of PO trading is like Las Vegas: the house
never loses. You just need a seasoned trader who can go toe to toe with the house
and come out on top.
Always remember there are times to buy and sell PO. The question is, do you know
the right time? And can you value PO within minutes and place a bid/ask price if
you have to?
In conclusion, an agency CMO prop trader needs to have an assumption based on the
historical volatility vis-à-vis effective duration, modified duration, and how
speed (PSA/CPR), in addition to knowing the VaR of each PO.