Aurum Wealth Management Blog

Moneyball & Mortgages

“Know something not everybody else knows.”
– Bill James, baseball writer, historian, statistician

Moneyball is a movie based on a book by Michael Lewis about the 2002 Oakland Athletics baseball team.  It is the classic underdog story mixed with statistics, a different way of thinking, and, of course, Brad Pitt for the ladies.  It was just nominated for six Oscars last month, including Best Picture.

Even though the movie takes poetic license with the story (as it really does not cover the top three pitchers anchoring the team), the true premise is about exposing inefficiencies in the marketplace.  The Oakland A’s adopted sophisticated analytics to more diligently evaluate players and to find those with the highest probability of succeeding.  For example, looking at batting average was the traditional rule of thumb, yet on-base percentage (which includes walks, which is just as good as hitting a single) is much better at assessing whether a player adds value.  While baseball teams used statistics before for evaluating players, they were not doing so with the robustness necessary to produce results different from the competition.  Many times teams would overlook solid players, simply because the typical scouting process had little efficacy. 

The strategy’s overall key is acquiring players (assets) at undervalued contracts (prices) and building a team with complimentary attributes, resulting in a winner.  It worked for Oakland as it made the playoffs in five seasons and set the major league baseball record in the modern era with 20 straight wins.

This reminds us of the mortgage-backed security (MBS) sector and a particular manager that specializes in these securities.  During the housing boom from 2003-2007, most managers believed the credit rating agencies could be relied upon for assessing the risk of securities.  This fund manager thought differently and disagreed with the blessing of the AAA-rating bestowed upon privately issued (non-agency) MBS in which the borrowers had low FICO scores and income insufficient to cover mortgage payments.  Of course, this is a matter of value, where paying par value of $100 and hoping to earn the yield did not provide a high margin of safety for investment.

After the housing boom came the bust.  Interestingly, overlaying a US housing price chart with the peak in 2007 to Japan’s real estate peak in the early 1990’s shows a very familiar path.  Although the futures markets shows a slight uptick over the next few years for housing on a national level, a slow grind sideways to slightly down would be more likely if the analog holds.

 Source: Koo, Richard, Nomura Research Institute, May 2011

With the downturn in housing from 2007 until present, many holders such as banks became forced sellers of these securities, pushing them down in price to the $50 or $60 range, taking into account high default assumptions (such as 20% for prime mortgages) and low recovery rates provided the opportunity to earn a much higher yield along with the recovery of prices to the$70 or $80 range.

Because the securities were subsequently downgraded by credit rating agencies as they would not return the par value of $100, some believed the securities were quite risky and shunned them.  Other very smart portfolio managers simply eschew the entire sector, knowing that powerful analytical models are necessary to assess the myriad of risks such as mortgage pre-payments (paying off early, refinancing, etc.) or determining the true underlying value of an MBS with thousands of underlying borrowers.

This manager, according to his words, ‘assuming nothing good will ever happen in the housing market,’ such as housing prices falling another 10% in the base scenario, utilized sophisticated models to find value where others could not.

The structure of the portfolio over time was also unique.  Given the two hypothetical bonds below (X & Y), which is the more attractive bond?















Fair Value at Maturity



Price Return Potential



Credit Rating



Risk Environment

Interest rates rise

Capital Markets in ‘Risk-off'

Best Scenario


Strong Recovery (rates likely rise)

Bond X will do well in an environment like last year, where a huge fall in interest rates (from 3.7% to 1.9% on the 10-year Treasury) provided a boon.  Conversely, it performs poorly if rates rise.  Bond Y on the other hand performs well in a strong housing and economic recovery, as the price revert to fair value and offer a high loss-adjusted yield, yet could fall in a risk adverse scenario.  Perhaps the best idea is combining the two types of bonds into a portfolio that does well in both environments with less interest rate sensitivity.

Securities overlooked due to a relatively longer duration or due to a low credit rating is where the inefficiencies sit for this manager.  Our clients and friends in the investment business likely know the manager we are discussing.  Despite its success, we still find the opportunity compelling, given its 6% yield, average price of $97, 5 year average maturity, and average duration of 2.35.[i]  This compares with the 5-year Treasury yielding less than 1% and paltry corporate bond rates at 2%.  Of course, there are a myriad of risks that the manager must balance, including rising interest rates, increasing prepayment speeds of agency MBS, and possible technical selling of non-agency MBS by forced sellers from European banks.

The opportunity will not be around forever though, as the $1 trillion non-agency MBS market shrinks by about 20% annually as pre-payments come through and with little supply from new issuers.

Whether analyzing baseball players or individual mortgage-backed securities, finding inefficiencies and constructing a complimentary team (or portfolio) is a key to achieving results.

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Important Disclosures

This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein.

Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein.  This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.  Persons should not use any information contained herein or linked presentations as a primary reason for investment or tax decisions.

[i] Data as of 1/31/12


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