Mortgage-Backs at Ticonderoga Custom Case Solution & Analysis

Evidence Brief: Mortgage Backed Securities at Ticonderoga

Financial Metrics

• The 10 year Treasury yield stands at 4.22 percent as of late 2004.
• The Federal Funds rate increased from 1.00 percent to 2.25 percent during the second half of 2004.
• Inverse Interest Only (IO) securities show yields exceeding 10 percent but carry extreme sensitivity to interest rate volatility.
• Option Adjusted Spreads (OAS) on mortgage backed securities have compressed by approximately 20 to 30 basis points compared to historical averages.
• Total portfolio exposure to mortgage derivatives represents a significant portion of the fixed income arbitrage strategy of Ticonderoga.

Operational Facts

• Ticonderoga utilizes proprietary prepayment models to forecast the Public Securities Association (PSA) speeds.
• Trading operations require daily liquidity to manage margin calls on repo financing.
• The fund employs a multi strategy approach but the mortgage desk is the primary driver of recent alpha.
• Risk management systems track duration and convexity but struggle with the non linear risks of Inverse IOs.

Stakeholder Positions

• Brian Sterling, Portfolio Manager: Believes the market overestimates prepayment speeds in a rising rate environment.
• Risk Management Committee: Expresses concern regarding the concentration of Inverse IO positions.
• Investors: Expect consistent absolute returns with low correlation to equity markets.

Information Gaps

• The case does not provide the exact internal rate of return for the specific Inverse IO tranches held.
• Specific counterparty limits for repo financing are not disclosed.
• The impact of a potential housing market slowdown on prepayment inertia is not fully quantified.

Strategic Analysis

Core Strategic Question

• Should Ticonderoga maintain or expand its Inverse IO position given the narrowing spreads and the Federal Reserve tightening cycle?
• How can the fund protect its capital if the yield curve flattens more aggressively than predicted?

Structural Analysis

The mortgage market faces a structural shift. As the Fed raises rates, the incentive for homeowners to refinance diminishes. This should theoretically benefit Inverse IO holders by extending the life of the high coupon interest stream. However, the compression of OAS suggests that this expectation is already priced into the market. Using a Sensitivity Analysis lens, the portfolio is highly vulnerable to a non parallel shift in the yield curve where short term rates rise faster than long term rates. This flattening reduces the carry and increases the hedging costs of the Inverse IO position.

Strategic Options

• Option 1: Aggressive Expansion. Increase the Inverse IO position to capture higher yields as prepayments slow further. This requires high conviction in the proprietary prepayment model. Trade off: High risk of catastrophic loss if long term rates drop.
• Option 2: Tactical Reduction. Reduce the position by 25 percent and move into less volatile mortgage pass throughs. Trade off: Lower potential returns and potential underperformance relative to peers.
• Option 3: Dynamic Hedging. Maintain the position but use Eurodollar futures and Swaptions to hedge against curve flattening. Trade off: High cost of hedging will eat into the yield.

Preliminary Recommendation

Ticonderoga should pursue Option 2. The risk reward profile of Inverse IOs has deteriorated. While the slowing of prepayments is a tailwind, the market has already bid up the prices of these securities. The fund should lock in gains and reduce concentration risk before liquidity dries up in the mortgage derivative market.

Implementation Roadmap

Critical Path

• Week 1: Conduct a stress test on the portfolio assuming a 50 basis point parallel shift and a 100 basis point curve flattening.
• Week 2: Identify the least liquid Inverse IO tranches for immediate liquidation.
• Week 4: Execute a phased sell program to avoid market impact.
• Week 8: Reallocate capital into short duration Treasury bills and high quality pass throughs.

Key Constraints

• Market Liquidity: Inverse IOs are notoriously difficult to sell in large blocks during periods of volatility.
• Model Error: If the internal prepayment model is flawed, the timing of the exit could be suboptimal.

Risk Adjusted Implementation Strategy

The exit must be disciplined. Ticonderoga should set hard stop loss limits on the remaining 75 percent of the position. If the OAS widens by more than 15 basis points, the fund must exit the entire position regardless of the prepayment forecast. This prevents the disposition effect from clouding judgment.

Executive Review and BLUF

Bottom Line Up Front

Ticonderoga must reduce its Inverse IO exposure by 30 percent immediately. The current strategy relies on a flawed premise that prepayment stability will offset the costs of a flattening yield curve. Spreads have compressed to a level where the margin for error is zero. The fund is currently picking up pennies in front of a steamroller. Capital preservation must take priority over yield chasing in this phase of the credit cycle.

Dangerous Assumption

The analysis assumes that historical prepayment inertia will hold. In a modern mortgage market with automated refinancing triggers, prepayments may stay higher for longer even as rates rise, destroying the value of the IO strips faster than the model predicts.

Unaddressed Risks

• Liquidity Risk: If a major dealer exits the MBS market, the bid ask spread on these derivatives will widen to a point where the fund cannot exit without a 10 percent haircut. Probability: Medium. Consequence: Severe.
• Financing Risk: Repo haircurts on mortgage derivatives usually increase during periods of Fed tightening. This could force a fire sale of assets. Probability: High. Consequence: Material.

Unconsidered Alternative

The team failed to consider a relative value trade where the fund shorts the IO strips and goes long the PO (Principal Only) strips. This would create a market neutral position that profits from the widening of spreads rather than the direction of interest rates.

Verdict

APPROVED FOR LEADERSHIP REVIEW