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.