Replies

This is what happens in an low short rate environment for mortgage backed securities.The CMO's get refinanced and that throws the cash flows completely out of whack.It's a boon to mortgage holders but not issuers, and FNM is the largest issuer in the world.They use the derivatives to hedge the pre-payment risk and manage the volatility that stripped mortgages have.They are now marked to market instead of marked to the duration of the mortgage, so if the option and swap was designed to hedge a 30 yr fixed rate mortgage at 7% and it's now at 5.5%, well, the CMO is going to take a huge haircut, even though if kept on the books, the hedge still works through the life of the mortgage.

This why Orange County went bankrupt in 1995, though their derivative hedges were still operable.Unwinding a hedge before its time due to nervous nellies can cause more problems than can be imagined.