August 10th, 2004, 6:27 pm
Basically, it is good to own (be long) convexity. When you have MBS, you are short convexity (which is bad). So what you do to offset this is to buy some very positively convex instruments into your portfolio. This used to be done via US Treasuries (because of their reliable correlation to rate movements), but is now mostly done via swaps and swaptions. What happened last summer was that due to falling rates, loads of people prepaid their mortgages and banks had to buy a lot of convexity (e.g. by going long treasuries, swaps, etc), which in turn drove rates even further down, which caused even higher prepays, which caused even more convexity buying, etc. It was like a dog chasing its own tail. When rates came back up, banks laid off their convexity hedges, which drove rates higher, etc. The MBS market has grown so big that its influence on the curve (via convexity buying/selling) is likely going to persist in the future.