Joseph Kohanik, CEO of Alpha Financial Software, offers an update on the evolution of the mortgage market amidst infrastructure changes and reviews some of the lessons this OTC market segment has learned from other existing and migrating CCP markets
In 2012 and 2013 the U.S. Agency Mortgage market continued its evolutionary infrastructure changes, taking the lead in global systemic risk mitigation of an OTC derivative. As these changes take hold it appears that what was intended by the regulators (more transparency, uniformity, systemic risk mitigation) in certain market segments, is only creating more confusion with a higher price tag. One thing is for sure, based on how this business is run today, the entrance fees need to come down a bit more in order to get more up-take. Yields are at historic lows, the Fed is pumping money into the market and with originations as the path to a rebound and additional market liquidity, more automation has to be the solution beginning now to enable mass production originations and the like. Remember there were 8.6 million originations in 2012, which is the highest amount since 2007; imagine if this market were 12-13 million per year.
I think it is important to review few significant mortgage market changes and analyze what this OTC market segment has learned from other existing and migrating central counterparty (CCP) markets. And, as the market moves forward into 2013-2014, the U.S. Agency Mortgage-Backed Security (MBS) market implementation has the capabilities of producing a market leading model for other market segments; with its To-be-announced security (TBA) netting and now pool netting and a future where you cover the rest with single pot margining. Just imagine a margining world where there is no cash requirement, but merely the segregation of a U.S. Treasury Note in your account at the New York Portfolio Clearing (NYPC).
In the Dodd-Frank Act, as it is called in the U.S. and the European Market Infrastructure Regulation, or EMIR as it is known in Europe, and as earlier mentioned, there are a number of key points that I want to review and offer perspective on now that we are more than two years into implementing these regulatory acts.
• Derivatives should trade on regulated exchanges or trading platforms
• Derivatives should be centrally cleared through regulated clearing systems
• For the good of the market, derivatives should have some sort of margining provision
Derivatives: regulated exchanges or approved trading platforms or ‘the same old way’
In the U.S. Agency mortgage market where annual trade volumes exceed $100 trillion annually, “THE” derivative security is called a TBA or “To-be-announced” security that is based on agency conformity on the loan side of the house (pun intended). These TBA securities settle every thirty days at which time firms net out trades where possible and connect to the Electronic Pool Notification system (EPN) so sellers can provide details of the actual mortgage pools that will be used to settle the derivative trade. Or, like in other “deliverable” derivatives markets the asset manager might choose to roll the contract to the next month thereby maintaining this open hedge against their portfolio of long mortgage pools. In actuality there are a number of options that can play out in the MBS clearance cycle that over time have been adopted in a similar fashion to regulated markets. Trade assignments, for example, have hit mainstream; assignments effectively slice off your settlement risk.
The TBA market, an extremely liquid market and one of the top five global OTC market segments stands at roughly $5.5 trillion dollars. As this market learned from other regulated derivatives markets, having centralized liquidity platforms, like ICE or the CME, could benefit the market, while appeasing OTC regulators. But from where I sit, for many firms that is just too big a leap frog to jump all at once. Setting one exact uniform price across all books would likely kick off margin calls in a market where more than 50% of the participants pay no initial margin or variation margin at all. And for those firms that do have Master Agreements, they like the flexibility of negotiated margin calls. Thus, market evolution has brought forth such legitimate OTC trading platforms, like TradeWeb or Bloomberg, who provide a strong offering of liquidity in the TBA market, as well as swap execution. For buy-side firms it can be said that there is an added layer of protection and counterparty risk mitigation by using such a trading execution platforms. Things like best-execution reporting via FIX and automated market price transparency via TRACE and integration to CCP’s are additional examples of how this market is doing things right!
Derivatives and central clearing and settlement
The TBA market has for many years had a platform at the MBS Clearing Corporation (MBSCC), now part of the Fixed Income Clearing Corporation (FICC), for performing trade clearance and settlement. However, today, many firms still opt-out of this offering. There are numerous reasons why this persists today. Some reasons are:
– low, but large, trade volumes that can be handled manually;
– The increased costs of doing business: FICC membership fees and clearance transaction fees can add fairly high costs to small and medium-sized firms. And although bulge bracket firms can more easily absorb these entrance fees, a fiduciary responsibility may dictate continuing bilateral management of trade clearance.
– In the new CCP model, as in all CCP models, once a trade is confirmed with the counterparty, the central counterparty (a.k.a the FICC) steps into the middle and guarantees settlement to both parties. In fact, the original trades are cancelled and two new trades are written against the FICC who is buying from the seller and selling to the buyer. As this change brings tremendous counterparty risk mitigation many firms still have not made the full-membership move.
Given the two reasons above, the ultimate pick up in risk mitigation may not be worth the cost to many firms.
I think that the number one reason why firms still do not and may never make the change to full FICC membership is found in derivatives margining.
Margining might just be the biggest hurdle for the TBA market.
As learned from other highly regulated markets, when managing derivatives, firms are required to post initial margin and a daily variation margin as prices increase and decrease from day to day over the life of a contract. The exchange sets ‘the mark’ and perhaps because it has always been this way or perhaps because of security types involved, firms live by this standard. If the exchange thinks there is too much of a run up in the market, they can increase margins overnight; not good!
For firms that currently have margining built into their infrastructure there is expected to be a margin savings. By facing off primarily against the FICC the number of counterparties decreases and thusly the number of trade pair-offs. Additionally, the future offers more savings via the movement away from cash margining.
All that said, with securities that are modeled very specifically at different firms, yes, TRACE can provide a decent market indicator as to where your modeled prices sit, but one price for the entire market is just not true in mortgages.
Plus in TBA trading more than 50% of buy-side firms never post initial or daily variation margin. This means that any firm who joins the CCP will now be required to post margin once the trade is confirmed and the FICC steps into the middle.
As we know, all derivatives central counterparties’ require both initial and daily variation margin. There is no wiggle room in this model. As such many firms want to stay with bilateral Forward Master Agreements in order to manage this on their own.
With solid points on both side of the ledger, the future definitely includes more originations and volumes that only automation can efficiently support, and the standardization that CCP’s offer should eventually drive the market in this direction, but that remains to be seen.