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Trading Agency CMO Inverse Floating BondsBy: Udo OnwuachiQuestion: I am a portfolio manager with equity trading experience and not fixedincome derivatives, how can I include inverse floating bonds without destroying myP & L?Answer: Poor P & L is as a result of a badly negotiated coupon formula and thelack of an understanding on how to analyze the collateral and the structure. Mygoal is to give you a worthwhile explanation of how to value and trade inverse

floating bonds in other to avoid heavy loses.These are some of the variables you should look at when decidind to bid/ask for aninverse floater:Collateral: WAC, WALA, CPN, SPEEDCoupon Structure: Bond Type, Lever, CPN, DM, CAP Strike Rate, Rate Reset,Underlying Index, Floor Strike Rate, YLD FWD, and the effective duration.Hedging: A portfolio of inverse floating bonds should be hedge with optioncontract. In buying option contract you should ask yourself these followingquestions:1. Which option contract should be used for the hedge? 2. Which month? 3. Whichstrike price? 4. How many contracts should be used?The first CMO was created by Credit First Boston in 1983. Some of todays traderswere still in elementary school, when the first CMO was structured, so they were

not trading CMO during the President Carters double digit inflationary rate orPresident Regans double digit interest rates. Thus, wont know how inversefloating bonds will react in a double digit inflation or interest rateenvironment. Not all inverses are equal. Most are volatile, while some are not.Also consider that you could be looking at PAC Inverse, SEQ inverse, PT inverse,SUP Inverse, Remic Inverse etc.In a structure of two tranches in comparison to an inverse with five structures, Ido not recommend you use recombination in valuing the inverse. In addition, theeffective duration signals the change in cash flows due to a change in prepaymentspeeds and interest rate changes: i.e. for those bonds that are linked to the 1MLibor, COFI or T12. A trader should know how the collateral prepayment speed,inflation, interest swaptions, convexity and forward yield curve when using the YBtable.

The inverse bond reset margin is vital. What is driving the index levels, in somecases the currency market, does play a role on most indexes like the Libor. Why?Foreign investors in pursuit of a better return on their investment might buyother currency instead of the dollar; this way, they get a better interest incomeon their currency, hence forcing the Fed to choose to save the dollar or thehousing market.For a trader who pays 64 cents on a dollar in the primary market, if the indexhits the strike it is customary for the inverse floater to trade around 63 centson a dollar to 65 cents on a dollar. In this case, the option is what the streetis looking at and predicting the index will decrease by 25bps. Furthermore, thegeneral idea is that a higher lever is what additional bps points when the inversefloater has hit the strike. However, if the index does not equal the value of yourinverse, the outcome could be anyones call.

As someone who has seen the inverse floating universe and the mistakes tradersmake, it is no surprise that most proprietary trading desk managing directors arehaving a sleepless night while the hedge fund star traders sleeps like a baby.Now, with all this talk about option this and option that, dont underestimate thepower of the collateral prepayment speed. If a good number of people walk awayfrom their mortgage payment, you can forget the high lever, for you wont haveenough cash to meet employee retirements or any other obligations for that matter.

In modeling deals you probably subscribe to INTEX meaning that you have to waitaround for INTEX to send you the cash flow. Now, If INTEX has not modeled the dealand you cannot wait, the programmers on your trading desk should know what to do.

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I recommend you sit down with your C++ developers and I tell them the variablesthat you need in other to arrive at the bid/ask price for the inverse floater. Inorder to trade profitably, an inverse floater bond trader must understand what isvital and whats not vital about the inverse floating bond asset class, such as,margin reset, forward curve, swap, the PSA/CPR at which the mortgage borrower ispaying back the loan and the OAS level etc. For example, I pointed a proprietarytrader in the right direction see below.This trader was going to sell 1,000,000 shares of bonds at $75.00 each, and I told

him to sell it for $88.50/32 base on my algorithmic calculations. In the end, thetrader was paid $88.50/32 for the bond. The major factor here was the CPR speedi.e. the rate at which people are paying back the loans they borrowed to buy theirfirst house in a case of default the investor will be in trouble. The lessonlearned here is the need for a trader to have a solid evaluation skill sets likemines for my experience and quant abilities allowed me to value the bond andarrive at a bid/ask price.The question is: Does your trader know when to buy and when to sell? Some inversefloating bonds are linked to the real estate business cycles. As someone who hasseen thousands of inverses and valued them given the interest rate environment,your fortune will take off. The fundamental issue is the structure and cash flow.The major loss that the fixed income derivative asset class has seen in the pastyears has to do with traders who did understand that the LIBOR index that the

inverse is linked to and the prepayment speed. These traders buy into strength andthen turn around to sell weakness. Most of the time, the trader does not have anexit strategy. As the hedge fund industry becomes a full grown adult, andinvestment banks are jumping into the game, which means the lack of the requiredspecialist skill sets to look at various Agency CMO asset classes. However, thegood news here is the volume of illiquid property that will turn into cash is veryhuge, hence, creating the opportunity for great wealth creation. While Wall Streetis the capital market center of the world and a most innovative one at that, Iexpect China, Japan, and India to follow suit in the creation of collateralmortgage obligations, hence calling for the demand for a hands-on, seasoned agencyCMO specialist. As someone who has seen the whole universe of Agency CMO inversefloaters, I know of and have seen inverse floaters and the struggles hedge fundmanagers and commercial banks trading desk have in arriving at a bid/ask price due

lack of trading experience.In conclusion, the paramount issue here is been able to submit a bid/ask in theprimary or secondary market of inverse floaters. In addition, making sure to havean entry and exit strategy. Your goal as a proprietary managing director is tomake sure that your traders submits the right bid/ask price when selling inversefloaters.Agency CMO inverse floaters is a very volatile asset class. If you structure asolid inverse floater you will be rewarded. If you buy an inverse floater backedwith poor quality collateral you will bleed to death money wise. Your Agency CMOinverse floater is only as good as the collateral backing it.Disclaimer: This is the private opinion of the writer and not that of anyorganization or institution the writer is solely responsible for these opinions.This is not advice to buy or sell security. This article is for educational

purposes only, and not to be use for any other purpose.