Tuesday, 22 September 2009

Implicit Regulatory Arbitrage: The Puts-Payers Trade

Yesterday’s post revealed how (and why) a large portion of the financial industry’s revenues came to depend on explicit regulatory arbitrage. This is fairly common knowledge, and should come as no surprise to industry observers.

What’s not so well known is that many ‘classic’ arbitrages, which appear at first glance to be regulation-independent, also depend implicitly on regulatory asymmetries to work. The textbook example is bond futures arbitrage. While anyone can buy bonds, some market participants are forbidden to sell bonds short. To express a bearish view, this latter group has to sell bond futures. This makes bond futures systematically cheap relative to cash bonds. Arbitrageurs have only to take the opposite side of this transaction to make easy money.

Of course, the classic bond futures arbitrage no longer exists (‘”too many eyeballs”), but other, subtler examples abound. Consider a trade that was very popular with fixed income arbitrageurs earlier this decade: the puts-payers combo. This trade involves selling Treasury puts and using the proceeds to buy payer swaptions, for zero net premium. Both the puts and the payers are struck slightly out of the money.

How does the trade work? If the market rallies or stays rangebound, the options expire worthless. But if the market sells off, the options are exercised, and the trader finds himself long Treasuries and paying fixed in swaps – in other words, long swap spreads. So, the trader is making the bet that ‘swap spreads will widen in a selloff’ – and he’s making this bet for free (remember, there’s zero net premium to enter this trade).

Is this a good bet to make? Let’s look at some history:

That’s a pretty strong relationship between two supposedly independent variables, and hints at some serious inefficiency in the bond market. What’s going on?

The answer is simple. Just as in the bond futures trade example described above, the arbitrageur in the puts-payers trade is taking the other side from entities who are forced by regulations to behave sub-optimally. In this case, these entities are the government sponsored agencies Fannie Mae and Freddie Mac.

Some background may be useful here. In the early years of this decade, Fannie Mae and Freddie Mac were massive players in the bond market. At the time, they had very large mortgage portfolios which were characterized by significant ‘negative convexity’. This characteristic meant that when the market rallied, they needed to buy; and when the market sold off, they needed to sell, in order to keep their portfolios properly hedged.

Now, Fannie and Freddie, being government agencies, faced restrictions on their size and trading activity. Consequently, they decided to do the bulk of their convexity hedging (described above) in swaps rather than in bonds, since swaps are off-balance sheet instruments, while bonds have to be reported. Every time the market sold off, Fannie and Freddie would be out there selling (paying) in swaps, in size. Swaps would therefore underperform bonds in selloffs; hence swap spreads would widen. (Note that the mortgage market is much larger than the government bond market; hence Fannie’s and Freddie’s trading actions, determined by the former, would invariably move prices in the latter.)

This pattern repeated for years and years: it was that rarest of beasts, a persistent and captureable anomaly in the market. Many arbitrageurs took advantage of this, via structures like the puts-payers combo.

Did these arbitrageurs generate alpha? Well, yes and no. Within the context of the bond market, the answer is yes: the agencies behaved sub-optimally, and thus transferred wealth to the arbs. But viewed at a larger scale, the answer is no: the agencies behaved rationally by paying the arbs to move their interest rate exposure off-balance-sheet. The arbs were therefore being compensated for a service they were providing; they were harvesting alternative beta rather than capturing alpha.

(This is just a particular case of the general truth that any alpha is merely a beta within a larger universe. In this case, bond-market alpha turns out to be service beta. I will return to this concept in future posts.)

Of course, even this persistent anomaly couldn’t last forever. The previous scatterplot shows data from April 2000 through March 2006; the following one shows data from April 2006 through August 2008 (Fannie and Freddie went into conservatorship in September 2008):

The inefficiency has all but disappeared. What happened?

The obvious answer is the correct one: over the years, Fannie and Freddie scaled back their interest rate trading activity considerably. Fannie Mae, for instance, shrank its mortgage portfolio (the “owned balance sheet”) from 917 billion in 2004 to 728 billion in 2007. Over roughly the same period, Fannie reduced its duration gap (a measure of the mismatch between assets and liabilities, and a strong proxy for the portfolio’s negative convexity) from over 1 year to less than 1 month, by buying swaptions and issuing callable debt. With a significantly smaller and better-hedged portfolio, Fannie simply didn’t have to trade that actively.

Obvious, yes, but only in hindsight. An arbitrageur who tried to play the puts-payers game after 2006 would not have made any money. Once the regulations changed (and make no mistake, Fannie and Freddie’s portfolio redesign owed a great deal to regulatory pressure), the regulatory arbitrage disappeared.

Why does any of this matter? The case study of Fannie Mae, Freddie Mac and the puts-payers trade highlights a theme that I will return to again and again on this blog: the importance of understanding the source of your returns. It’s not enough to spot an inefficiency (opportunity) in the market; you must also know why the inefficiency exists. Only then can you avoid being blindsided when circumstances change and the opportunity disappears.

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