The deadline to comply with TMPG’s new margin requirements for MBS was fast approaching for the buy side. Lynn Strongin Dodds explores the operational and legal burdens they face.
The deadline of June was fast approaching to comply with the US Treasury Market Practices Group (TMPG) new margin requirements for forward-settling agency mortgage-backed securities (MBS) but buy side participants are still at the starting line. The operational and legal burdens were proving too great and as a result the target date was recently pushed back the deadline to December 2013.
In a statement just released the TMPG recommends that market participants make significant progress towards margining forward-settling agency MBS exposures by early June 2013 and substantially complete the process by December 31, 2013. It also advised a risk-based approach whereby market participants should continue to implement the practice recommendation on a rolling basis and prioritise their most material exposures.
In addition, the TMPG clarified two aspects of the margining recommendation in response to questions received from market participants: the types of agency MBS transactions that are within the practice’s recommended scope and what constitutes “forward-settling.” As to the margining practice, at a minimum, it proposes applying it to four broad categories of agency MBS transactions: To-Be-Announced (TBA) transactions, specified pool transactions, adjustable-rate mortgage (ARM) transactions, and collateralised mortgage obligation (CMO) transactions.
The TMPG also recommends that margining be applied based on the type of agency MBS transaction and the existing market trading and settlement conventions for each transaction type. For TBA, specified pool and ARM transactions, margining should be applied at a minimum, for all trades where the difference between trade date and contractual settlement date is greater than one business day. As for CMO transactions, this covers all trades for which the difference between trade date and contractual settlement date is greater than three business days be subject to margining.
The main driver behind these changes, as with most of the current wave of regulation, is risk aversion. While the posting of margin is common practice in the trading of agency MBS between members of the Mortgage backed Securities Division (MBSD) of the Fixed Income Clearing Corporation (FICC), it is not currently required for transactions with non-members. Most purchases and sales of agency mortgage-backed securities are settled at least one month after the deals are struck between counterparties. The length of the timetable was seen as creating a potential loss by one of the two counterparties should either fail to deliver securities or make the required payment.
Last November, the TPMG tried to rectify this by publishing recommendations for buyers and sellers to collateralise their transactions and sign documentation outlining how each counterparty will be made whole in the event of a default or bankruptcy of the other. According to the group’s estimates, about $750 bn to $1.5 trillion of the $5 trillion agency mortgage backed market represents gross unsettled and unmargined dealer to customer trades. As an example of the costs that could be incurred the group notes that a buyer could end up spending an additional $5m to buy replacement securities for a $100m deal if the seller went under and the value of the assets rose by 5% between the time the deal was struck and the settlement date.
Although few disagree with the rationale, most did not believe the implementation date of June was realistic. One issue was that TPMG edict was not legally binding and there were a slew of regulations that were occupying the fund management community’s time and resources. Unlike the Commodity Futures Trading Commission (CFTC) which is an independent agency of the US government that regulates futures and option markets, the TPMG is a committee of buy and sell-side market operations professionals chaired by Morgan Stanley and sponsored by the Federal Reserve Bank of New York.
However, although it may not have the teeth of the CTFC, it does yield influence and while deadlines may slip, participants are expected to toe the line. The main reason broker-dealers conducting business with fund managers will implement these changes is because the threat and size of the systemic risk for uncollateralised forward settling agency MBS is enough to send a chill down their respective collective spines. The extension has been most welcomes as there were doubts that anyone would have been able to meet them.
“It is not like the current regulation with OTC swaps,” says Joseph Sack, independent consultant and managing director of Association of Institutional INVESTORS, a trade body of investment advisors. “These are recommendations and there was no consultation process. “There are still a lot of unanswered questions and not everyone is on the same page on the legal side. The template they are using is an updated version of the Master Securities Forward Transaction Agreement (MSFTA) which was first introduced by SIFMA (Securities Industry and Financial Markets Association) in 1996. As a result, the general mind set is that the June deadline will not happen because the industry will need longer to prepare. I don’t think we need to push the can down the road to 2014 because if we do, we will have the same problem in terms of preparation. People would delay it. I think a further extension though of three to six months would help.”
Elisa Nuottajarvi, SIFMA Asset Management Group, The Asset Managers Forum also agreed that more time is needed. ”Everyone agrees with the recommendation to margin in general and the need for risk reduction. However, market participants were concerned about timing of the requirement. The buy side needs to negotiate agreements for each of its accounts, which can run into thousands of documents. Client consents and amendments to management agreements may also be necessary in many cases. Additionally, there were a number of open questions as to the application of the margining recommendation that require clarity, such as the meaning of “forward settling”. The clarifications and delay of implementation announced yesterday are welcomed by our members. It is clear many market participants will not be able to fully comply by June, especially given other regulatory requirements like the transition to central clearing for swaps, and therefore that the extension was necessary and appropriate.”
Joseph Kohanik, chief executive officer at Alpha Financial Software, echoes these sentiments. “I do not see how participants are going to meet the requirements to post margin on a daily basis when over half of the buy side have never done so. The lack of standardisation on the legal side will also create challenges. In the past only one counterparty might have put up margin but the new document calls for both counterparties to collaterise their transactions. This could potentially mean a buy side firm which for example, had 300 accounts, would have to create 2400 MSFTAs with each account and counterparty.”
Although acknowledging that there would be legal and operational costs, the TPMG did not offer any concrete numbers. The Association though believes the cost of implementation of the new MBS margining regime could be fairly significant for asset managers mainly because of the additional staffing requirements. It notes that “the anticipated new regime will entail manual calculation and contact with counterparties, custodians and other service providers. Also, buy side legal teams will be dealing with as many as 20 different forms of agreement from their sell-side counterparties. Each sell-side firm, on the other hand, will basically be negotiating the same contract with each of its asset management counterparties.”
“Many do not have resources in-house and they will have to hire in new people to meet the recommendations,” says Kohanik. “The TPMG set a deadline but did not look under the hood to see what needed to be done to comply. It is a difficult thing for companies in this climate to invest in the future because many want to see the efficiencies right away and I do not see the benefit of this for another 18 months. As a result, it could have a short term impact on the return on investment.”
There are steps that firms can undertake and issues that can be addressed now, according to Sack, noting that the Association has issued guidelines on implementation. First on the list is client outreach. This entails engaging with the firm’s client relationship area and developing a plan whereby it can accurately measure the full scope of customers, dealers and their custodians. Next is the negotiation of contracts which will be based on the newly polished SIFMA template. The Association notes that while it is appropriate for asset managers to use a master agreement with broad, universal terms when finalising documentation to implement the new TMPG margining regime, any provisions that are unique to a particular transaction should be negotiated at arm’s length by the parties to the transaction.
It is also important for asset managers to ascertain that counterparties are pursuing implementation of a fair and reasonable MBS margining regime in a manner consistent with the thrust of the TMPG recommendation. “For example, it is not entirely clear that all dealers are on board with two way variation margin. Even when they apply, certain dealers might suggest that initial margin apply to the buy-side party in some instances but not the dealer—any such suggestions should be thoroughly discussed with the counterparty,” according to the guidelines.
In addition, asset managers should recommend to counterparties to have their counsel review the 2012 version of the MSFTA document. Not surprisingly, it is not practical to begin negotiations using the 1996 version. Lawyers should also consider cross referencing other relevant arrangements especially omnibus relationships and tri-party arrangements. As for netting, buy-side firms are clearly supportive of creative approaches to netting margining arrangements across the various financial markets, as long as they are feasible operationally and are consistent with regulations applicable to others, such as exchanges, custodians and futures commission merchants (FCMs).
Last but certainly not least is agreement upon definitions. While the TMPG pronouncement was generally understood by market professionals, terms should be delineated to assure clarity of meaning and interpretation should questions arise in the future. For example, what are the technical parameters of a “forward” transaction? Firms will have different demarcations but the whole process could get lost in translation if participants are not reading from the same script.
