In a recent Bloomberg article, it was mentioned by the Credit Suisse Group that the Federal Reserve could consider selling options to primary dealers in order to help them ease imbalances in derivative positions that are amplifying swings in interest rates (see Bloomberg article). This sounds interesting, given that a similar strategy was used in 2000 in the form of liquidity options to help head-off potential Y2K funding problems. In addition to options, investors could also use swaps, swaptions, and Treasuries to help hedge interest rate risk.

Of course, such a hedge position may not be possible for others if the new regulation being proposed by the Obama Administration is put in place (see the Washington Post article). One aspect of the new proposed regulatory framework would require firms to retain a stake in each securitized product that is developed. Furthermore,

"The plan also would prohibit firms from hedging that risk, meaning that they could not make an offsetting investment"

While I understand the reasons for proposing such a restriction - the hope that it will cause investment banks to develop less risky, less leveraged, and less opaque products, thereby preventing another 2008 credit meltdown - it seems this could be achieved in a less restrictive, yet more focused way. Forcing companies to keep a piece of the structured security (and subsequent risk) on their books appears counterproductive when it makes more sense to allow and encourage companies to hedge this risk, even if it means passing the risk onto another investor such as a hedge fund willing to take on the risk (and reward). Forcing companies to keep risk on their books will only repeat some of the same problems that various investment banks faced in 2008 when they were unable to sell and shed structured product risk once the credit crunch unfolded.

While forcing these companies to keep some of the structured securities on their books could make it more likely that they would offer less risky products, is this what we really want? One of the benefits of securitization is its ability to free-up capital for more productive uses. While this process certainly got out of control and was misused in some instances, placing a blanket restriction on what can be sold also places similar restrictions on risk reduction and the flow of capital into more productive hands - something we cannot afford to restrict, especially at this time. Here is hoping that the current proposal is just that, a proposal, and that any final legislation will consider the unintended consequences and be more focused on the specific problem that needs to be addressed - uncontrolled risk taking.

There is an interesting article from Bloomberg that discusses how TIPS (Treasury Inflation Protected Securities) are not living up to their goal of protecting against inflation. The principal for TIPS increase with increases in the CPI, yet many bond holders do not feel that the CPI is properly tracking inflation, in particular the large price increases in gasoline and soft commodities, such as corn. Even as prices have increased over the last 18 months, yields on TIPS relative to Treasuries have essentially stayed the same.

As an alternative, some investors are using swaptions, which when purchased give the buyer the right to purchase a swap. Swaptions are essentially options on interest-rate swaps. Inflation swaps allow one party to pay a fixed rate in exchange for the inflation rate. Lately, swaptions have been better at gaining value when the expectations of future inflation increase, even if the CPI is not keeping up. As an example, in April and May one-year inflation swaptions returned about 0.3%, compared with a 2% loss by TIPS of all maturities. Nonetheless, even while reacting to inflation better, some investors still prefer TIPS since they are backed by the government, unlike derivatives that depend on the credit quality of the issuing firm.