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Optimizing Mortgage Credit Hedging with MDX Swaps
MDX swaps are designed for hedging mortgage credit exposures. The underlying obligors within MDX indices represent a wide and diverse range of mortgage borrowers whose credit performance is highly correlated with other mortgage instruments. To adjust for credit and structural difference between MDX swaps and other mortgage products, hedge ratios are likely to be employed. Vista has compared the historical performance of MDX swaps to several different mortgage structures to understand relative price movements. These observations help demonstrate how hedge ratios may be used to match expected performance under differing market conditions. Access to this study and other resources are provided below.
Mortgage credit hedging takes many forms and is typically tailored to match specific mortgage exposures. Buying protection via CDX IG and HY swaps is the most common approach to hedging mortgage credit risk with short equity positions in housing or consumer-related stocks also playing a role. So why use MDX swaps and how correlated is their performance to other mortgage products?
MDX swap performance is directly tied to mortgage borrower performance – rather than indirectly linked through corporate borrower performance as is the case with CDX. Hence, at a macro level, MDX swaps prices should correspond well to expected changes in overall mortgage borrower performance. Within this general context, the highest correlations are likely to be found when mortgage loans or securities have borrower characteristics that closely match those of the MDX indices. As borrower and collateral characteristics begin to vary from those in the MDX index, market participants may need to utilize hedge ratios to improve their expected correlations. Adjusting for differences between the credit characteristics of MDX reference borrowers and the spectrum of residential borrowers can be achieved through direct comparisons at the loan or aggregated level. This is already a common practice today.
Structured mortgage products and MDX Swaps can have very similar borrower credit profiles and yet have very different performance under changing market conditions. Attachment points triggered by changes in prepayment rates and loss allocations determine sequential write downs on structured mortgage products. Meanwhile, MDX swaps are unstructured and have a uniform allocation of Credit Event losses. As a result, when Credit Event expectations rise and fall, structured mortgage product pricing can move unevenly with MDX Swaps. This effect is most pronounced on subordinated tranches, which have the greatest sensitivity to changes in borrower performance
Historical Pricing for CRT M2s, B1s, and MDX Swaps demonstrate how relative price movements vary under different market conditions. To create this study, Vista used a 5-day moving average of daily price changes of M2 and B1 Vista CRT Indices™ and MDX swaps. Vista CRT indices™ are based on daily prices of both CAS and STACR® securities aggregated by vintage and subordination – and weighted by amount outstanding (see www.vistaindex.com/crt-indices). Historical MDX swap pricing has been estimated by Vista based on a model developed in collaboration with dealers and mortgage industry experts. Vista CRT indices and MDX swap vintages are rolled in January of each year. The study covers the period from January 1, 2018, to December 29, 2023. Please click here to download the data used in this study.
Subordination Class appears as a key factor driving the differences in structured security performance compared to MDX swaps. The chart above suggests the range of price movement variability is roughly double for B1 tranches vs. M2 tranches under most market conditions. This suggests that lower attachment points generate consistently greater differences in price movements compared to higher attachment points. Furthermore, as overall spreads widen, comparative volatility increases as well. Volatility chart is below:
Aligning credit and structure with MDX Swaps through hedge ratios is important to achieving risk management objectives. As the market prepares for MDX swap trading and clearing, additional data and hedging techniques are expected to emerge. Actual MDX swap trading prices, when available, should further refine these approaches and demonstrate the effectiveness of using MDX swaps for hedging purposes.