“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.
It found its hedge in the to-be-announced (TBA) market, which is liquid and transparent. In a TBA trade, a buyer and seller agree on general terms such as the type of security, the coupon, face value and price, but not the specific pool of mortgages. Trades settle only once a month. Until two days before settlement, sellers are free to choose which pool of mortgages to offer, so naturally they pick the worst-performing pool. This worst-to-deliver option is understood and priced into the trade.
TBA contracts work as hedges because if rates rise and mortgage prepayments slow, the value of the underlying MBS pool would drop but the payoff from shorting TBA contracts would generate positive returns to offset that drop, explains Aditya Agrawal, a senior portfolio analyst. Google also mitigates credit risk by negotiating collateral postings with its counterparties, he adds.
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.
Because Google's investment strategy is a hybrid of relative value and absolute return, having a hedging tool “helps us manage that dual mandate in a rising interest-rate environment,” says assistant treasurer Tony Altobelli. For operational efficiency, treasury systems helped the hedgers build a fully integrated user portal.
“During a rising rate environment, it becomes critical to protect our portfolio returns,” Chang says. “Our hedging strategy already proved invaluable during several instances when markets were volatile and we needed to tactically manage our risk.”
See a slideshow of the 2012 Alexander Hamilton Award winners here.
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