Suppose that a manager buys an adjustable-rate pass-through security backed by Freddie Mac or Fannie Mae, two government-sponsored enterprises. Suppose that the coupon rate is reset monthly based on the following coupon formula:
1-month LIBOR + 80 basis points
with a cap of 9% (i.e., maximum coupon rate of 9%).
Suppose that the manager can use these securities in a repo transaction in which (1) a repo margin of 5% is required, (2) the term of the repo is one month, and (3) the repo rate is 1-month LIBOR plus 10 basis points. Also assume that the manager wishes to invest $1 million of his client’s funds in these securities. The manager can purchase $20 million in par value of these securities because only $1 million is required. The amount borrowed would be $19 million. Thus the manager realizes a spread of 70 basis points on the $19 million borrowed because LIBOR plus 80 basis points is earned in interest each month (coupon rate) and LIBOR plus 10 basis points is paid each month (repo rate).
What are the risks associated with this strategy?