So, you’ve just taken over as CEO of a modest-size mortgage banker which does its own hedging, or of a large aggregator buying from correspondents and brokers nationwide. It’s your first gig as Top Dog, and your background is in sales, or accounting, or ops. The capital markets area (used to be called Secondary Marketing, but Capital Markets sounds so much cooler!) is impressive, with intense-looking nerdy types each staring at three monitors (makes browsing Facebook, ordering on Amazon, and sorting out one’s Fantasy Football strategy so much easier!).
Your EVP of Capital Markets, an impressive-looking fellow in his thirties sporting a Stanford MBA, motions for you to come into his office while he finishes up a Very Important Trade.
“Sorry, I’ve just been adjusting our synthetic put position — and I’m happy to explain what that is if it’s not something you’re already familiar with. What can I do for you?”
What do you say?
Being an old codger, and since this is my chapter in my own book, I’ll get around to the answer, but by way of a few stories about the old days.
The Volatility Commandos
My first job in the industry was being the proverbial junior bottle-washer; but I did pretty well at it, so I was invited to go to my company’s annual sales conference that first year. The motivational speaker was a famous guy whose announced topic was The Secret of Success. Now, I figured that was pretty incredible; most folks probably had to work for years, decades even, before figuring out the Secret, and here I was, getting it handed to me right off the bat.
So, I got to my seat early, notebook and pen in hand; and, to make a long story short, it finally turned out the Secret of Success was — Just Show Up. I was disgusted. What a rip! Surely the Secret was something subtler, more ingenious, than that!
It was wasted on me; but, of course, years later, I came to understand that “just showing up” is indeed one of the things that most differentiates everyone who is successful in sales (or business, or life!).
With experience, I’ve added my own corollary, however: And don’t blow up.
Long-term success does not go to the smartest, or the most polished, or the best at marketing, or the most efficient at operations, or, for that matter, to the best at best execution. It goes to those who survive.
Hey, the EVP just asked if he can do something for you!
“You sure can. Don’t blow up.”
“Oh,” says your EVP, after a brief pause. He seems a bit let down that you didn’t give him a chance to explain synthetic puts[1]. “You’re worried about our betting on interest rates? Don’t worry, that’s something only old-time Secondary Neanderthal-types would do. We never assume we’re smart enough to know which way rates are going to go, sir. No, all our focus is on the spreads — the price or yield difference — between various hedge instruments and the actual assets we’re hedging.”
The EVP gestures to a number of graphs that are taped up on the wall, and a bevy of Bloomberg screens showing the price relationships among various MBS coupons and Treasury futures.
What do you say now? Hold your horses; perhaps it would be best if I told you another tale.
During the 1980s, I helped to build two of the first jumbo securitization conduits, one of them at a storied Wall Street firm famous for its trading expertise. Years later, this firm would be a casualty of the Great Mortgage Meltdown, but when I worked there, blowing up was unthinkable. And here’s why.
The Fixed Income department had been created not that many years earlier by two of the smartest, most successful — and most unusual — men on Wall Street. Jimmy (not his real name) was short, soft-spoken, intensely intellectual; Mannie (ditto) was a man mountain, tough-talking, the guy you’d want to have on your side in a street brawl. Together, they were a money machine. But it wasn’t always that way.
During the 1970s, at the dawn of the era of financial futures, they’d been partners in a small hedge fund which made tremendous amounts of money trading the cash-futures basis, which is a perfect example of a theoretically low-risk spread trade. And everything went swimmingly.
Until it didn’t.
One day, the basis got way out of whack. Well, it would surely eventually revert to the normal relationship, so that just meant they could make money shorting more of what was rich and buying more of what was cheap.
And then the basis got even more out of whack.
Now, spreads may or may not revert back to the mean. But even when they do, you have to be able to hang on long enough to book the profit. And that can take truckloads of capital. That can take sell-everything-you-own-and-then-borrow-and-you-still-don’t have-nearly-enough capital.
Losing money may or may not make you broke. Running out of cash — a liquidity crisis — will almost always make you broke. And that’s what happened to Jimmy and Mannie. If they could have ridden the trade out, they would have made big money. But they’d put on a trade that they couldn’t ride out. Now, some computer models will tell you that those market conditions come around only once every hundred, or every thousand, or even only every two thousand years. And then all of a sudden it’s 2007, and those once every-other-millennium market moves take place twice in one week.
Stuff happens.
So Jimmy and Mannie went broke. But they got lots smarter. They’d learned their lesson; now, they were determined to become volatility commandos. Nothing was ever going to blow them up again. And that’s the philosophy they put in place when they set up Fixed Income at that storied firm I joined in 1985.
Does that mean they’d become Wall Street Wimps, content with mediocre returns? Not a bit. In fact, this firm epitomized a style of doing business that is common to many of the most successful mortgage firms I’ve known over the past thirty-five years, from the smallest mom-and-pop broker to the largest aggregator: a blend of hard-hitting aggression on the one hand, and obsessive, paranoid oversight on the other. You just have to learn to drive with one foot on the accelerator and one foot on the brake. It’s an acquired skill.
“So let me ask you something,” you say to your EVP of Capital Markets. “Have you ever lost money or been part of a secondary operation that lost money? I mean, big money?”
“No sir,” says the EVP. “And I’ve been hedging mortgage pipelines since 2017.”
“That’s a pity,” you mutter. In your mind you’re leaning back and lighting up a really fine cigar, but of course that’s not possible these days.
“Sir?”
“How about pull-through behavior? When’s the last time you got together with operations to talk about fallout trends?”
“I assure you, we’re on top of that.” Your EVP frowns. “I can show you a dozen charts and graphs. We regularly update our pull-through functions and feed those into our hedging model.”
“That’s not what I asked,” you say. “Is it.”
Silence.
Now, this smart young fellow might one day be molded into just the right man for the job. But you want a volatility commando running Capital Markets. In fact, you want a team of volatility commandos working for you: Ops commandos, Compliance commandos, Legal commandos!
We’ll explore this more in the next section.
[1] For a terrific discussion of synthetic puts, see Appendix Two to Chapter 2 of this volume.
Read the rest of this chapter in The Mortgage Professional's Handbook!