Central clearing isn’t just new credit default swaps. Linedata Services’ Joe Kohanik explains how the use of a central counterparty model for the clearing of U.S. mortgages will surely bring many benefits to market participants.
With the global OTC marketplace in the midst of a shakedown and government regulators deep in muddle, as we emerge, it is obvious that central counterparty clearing (CCP) models will play an important part in providing more transparency and risk oversight in certain pockets of the OTC world. One of those pockets is the U.S. mortgage market. I often laugh when people refer to it as a “niche market” because in reality the U.S. mortgage market by most industry standards is viewed as the largest bond segment in the world at roughly $10 trillion in size and with annual trade volumes in excess of $100 trillion.
Awaiting final regulatory approvals and run through a newly formed entity New York Portfolio Clearing (NYPC), the MBS CCP model was first recommended in 2003 in a framework document published by the Fixed Income Clearing Corporation (FICC). The FICC clears about $4 trillion in U.S. fixed income trades each day. FICC member firms can either be participants or full-clearing members in order to access to the central counterparty. Lets take a look at this market, who trades in it and the benefits of this CCP.
The U.S. Mortgage Market
The U.S. mortgage market is an extremely complicated equation when one thinks about the tens of millions of individual borrowers translating into amortizing, securitized bond cash flows that payoff millions of individual and corporate investors. In thinking about the market from a investment risk perspective, it can be easily divided into two primary groups, Agency and Non-Agency.
The Agency market is backed by Fannie Mae, Freddie Mac, Ginnie Mae and more recently, the U.S. Government. Agencies guarantee cash flow payments to the bond holders and the U.S. Government backs the agencies. Despite some of the issues the agencies themselves had, the agency market went through the crisis with little slow down in mortgage originations and securitizations and continues to be robust. Fixed rates mortgages are the meat of the agency market and banks are held to fairly stringent criteria when feeding loans into these conventional programs.
The Non-Agency market is filled with private label issuers that write mortgages and then securitize them with guarantees that can be categorized as not U.S. Agencies. During the crisis, as one would expect, spreads between agency and non-agency paper became extreme, going from perhaps a 25bps norm to 200+bps. This non-agency market virtually shut down after Lehman’s collapse. It has picked back up as volatility and spreads, as expected, have brought more entrants and bids back into this market.
Who trades MBS and where is the liquidity?
As seems to be the OTC standard, large banks and broker/dealers provide most of the liquidity in mortgages. The asset management community who use those securities as investments consists primarily of governments, banks, insurance companies, investment management firms and hedge funds.
Managing a mortgage portfolio can be a daunting task. A portfolio of $100 million containing 200 pools can easily translate into 1,000 data points required each business day. Different agencies, different factor dates. But, it remains fact that the past three years has seen the majority of new money flows into fixed income products. Since mortgages represent 26% and 35% of the U.S. fixed income market and the Barclay’s U.S. Aggregate Index, respectively; most fixed income managers needs to have mortgage exposure. This investment and further, new money flows into fixed income adds liquidity to the mortgage market.
Portfolios of mortgage-backed securities today are traded either over the phone or electronically on platforms like TradeWeb and Bloomberg. Both Agency and non-Agency mortgages are traded as individual pools, also known as a specified pool trade. On the Agency side there is an additional liquidity tool, called the “To be Announced” forward market, where settlement of pools occurs once per month. As one might surmise, TBA’s are primarily used as hedging instruments. Given the forward nature and the fact that many TBA trades are in excess of $500MM per block, collateral management is a big component of mortgage hedging. On the liquidity side, agency paper is much more liquid than non-Agency paper.
Benefits of MBS CCP
At this point in history, a central counterparty is deemed to be the answer for the regulators of the financial industry. By having a central counterparty, the regulators will certainly be provided more transparency into market participants. Their hope is that more information will provide the CCP more direct, on-going monitoring tools to help avert crisis. And, in the event of a participant going out of business, the CCP will provide a back stop mechanism for all participants.
The Central Counterparty model for U.S. mortgages will surely bring many benefits to members, as well. Two key benefits stand above the rest.
1. Settlement risks will go down dramatically. In a CCP model, once a trade is matched, the FICC will step into the middle of the trade, thusly removing the many different counterparty risks that must be managed in today’s process. This is huge for the OTC market!
2. Capital charges will go down. Today, firms are posting and managing capital charges by counterparty with all of the additional overhead costs. In the future model, the posting of collateral for margin purposes will see many efficiency gains. Aside from only having one daily margin posting, the biggest impact will be the ability to cross-margin your positions; use your long Treasury’s to cover TBA mortgage margin requirements. This will free up capital to be employed elsewhere in your business. Another BIG win!
If you understand these two facts, its easy to see why ‘the herd’ willingly accepts the MBS CCP. Whether your firm is in mortgages now or you plan to be in the future, the MBS CCP just might be the solution for your firm!