For many professional, 2014 will be the year that they finally tackle the new MBS margining requirements set out by the TMPG. Despite best-laid plans, Joseph Kohanik, of Alpha Financial Software, explores the challenges financial institutions face as they aim to adopt new margin requirements to meet new industry recommendations.
As the New Year quickly approaches, 2014 will bring some dramatic changes to the U.S. Agency Mortgage market. The change having the biggest impact has to do with TBA margining. As one of the largest global bond segments at approximately $6 Trillion, it is hard to believe that the majority of financial firms trading this asset class have never had to post margin when trading. In fact the New York Federal Reserve bank estimates that somewhere between $750 Billion and $1.5 Trillion of forward settling trades goes un-margined. From a risk mitigation point of view and in thinking about systemic risk, TBA margining will certainly move us in the right direction. However, this change and given the number of market participants, is equivalent to turning a large freight ship, whereas the governing bodies, in my estimation, are being too aggressive with production timeframes. One caveat of the recommendation is the words “substantially complete” by January, 2014. This means that firms do not have to be 100% complete as of the beginning of 2014 but they must be well on their way to completion. For many firms this interpretation will be spun in many ways.
So, let’s look at some of the hurdles that make adopting MBS margining a larger undertaking that really requires, at a minimum, two to three years to fully adopt as opposed to 12 months or less to be substantially complete when one includes comment periods and final governance recommendations.
Master Securities Forward Transaction Agreement (MSFTA)
Negotiating the MSFTA is a big hurdle to cross for a successful implementation of TBA margining. As a follow through on the TBA margining recommendations, the Securities Industry and Financial Markets Association (SIFMA) updated the MSFTA to bring the industry together in standard legal document. In working with the Treasury Market Practices Group (TMPG), who wrote the TBA margining recommendations, together they set the high level recommendation of bi-lateral margining but left room for further interpretations of the recommendation by leaving a substantial amount to be negotiated in the legal agreement. This has allowed market participants to further shape the specifics through negotiations on most of the contract specifics. The ease of implementation will be highly dependent on how consistent one can make this agreement across all trading counterparties. A few things are certain when it comes to negotiating the MSFTA, the larger the asset manager, the more attention they will get and most likely the more consistency they will have across counterparties, meaning an easier implementation of TBA margining.
For many smaller firms, it could mean that they are literally cut-out of the market for a period of time and until they can get the dealers’ attention to negotiate a contract. Fewer participants could mean less trade volumes and less liquidity. It is certain that the TMPG did not intend for this result when mitigating systemic risk, but aggressive timelines could have such an impact on the market. This remains to be seen.
MSFTA & Eligible Collateral
When negotiating the MSFTA, another big hurdle is negotiating eligible collateral. At the onset and when dealers began meeting with buy-side firms “the deal” was “cash collateral only.” A smart lead-in but after hearing of broker demands the TMPG responded and further clarified that dealers must be willing to accept other forms of highly liquid collateral, such as mortgage pools, treasuries, corporates and even asset-backed securities, along with appropriate haircuts. By making this clarification, it made this hurdle much easier to pass and should provide the smaller firms more bargaining chips in contract negotiations.
Private Client Mandates
The potential need to revisit private client mandates could present another big hurdle for asset managers. All money managers have private clients or high net worth individuals. And, for each client there are specific mandates for managing and safekeeping assets. For smaller firms this might mean hundreds of accounts and for large asset management firms this might mean thousands of accounts. Reviewing client mandates is a huge undertaking and could take years to reach out, educate and get clients to approve the Master Securities Forward Transaction Agreement (MSFTA) version 2012.
So what this means is that initially and until client reach out is complete, these market participants will most likely be cut-off from trading TBA’s, ARM’s and CMO’s that settle outside of the settlement cycles of T+1 and T+3, respectively. This is sad but true. We will see how this plays out over the next few years but one resolve could be that the manager decides not to reach out to the client and will switch to other assets classes and permanently withdraw from the MBS market.
If an investment manager decides to reach out and re-open a client mandate, there are common themes that need to be reviewed and perhaps updated for a typical client. For example, most mandates typically state that the investment account must be 100% invested and all monies put to work at all times, unless there is a market crisis event and further that the account maintain “X” percent of mortgage exposure.
The result of MSFTA negotiations for some firms could mean that cash needs to be readily available as collateral to meet margin calls. Hence, a manager who is exclusively using cash collateral might have to sell “same day” securities in order to meet the call obligations. For any asset manager, being forced to sell a security to cover an operations item could directly impact performance and also have unwanted tax consequences on the clients’ account. And, having to adjust a portfolio, in the first place, to be able to meet cash collateral needs could also be a drag on performance, especially in today’s QE3 environment.
Looked at from another angle, suppose the investment manager has negotiated the MSFTA to include the use of securities as collateral and they are 100% invested in the market, if a collateral call should arise, depending on the type of account, the manager may be required to set up yet another custodial account, that someone must pay for, to segregate collateral or pay the transaction costs for moving collateral to the counterparty. The costs associated to support TBA margining will impact account performance over time and especially if the negotiated margining thresholds are a small percentage relative to the account size, causing frequent margin movements.
In another example, in many older, long-term relationships the client mandate might contain a clause, “no margin activities,” with the underlying definition, of 15 years ago, being that the manager will not borrow funds to purchase securities (a.k.a. leverage). Over the past 15 years, the word “margin” has taken on new context and meaning with the evolution of derivatives and so older mandates might have to be dusted off and rewritten as part of adopting TBA margining. Ask any asset manager who has been in existence for over 15 years and they would most likely have the same opinion. They would be very hesitant to voluntarily call a long-term, happy client and ask them to re-open the original mandate, when doing so could have unintended consequences. Maybe the client puts forth new rules and restrictions and in some cases maybe the client decides to negotiate new fee structures or even worse put their investment mandate out for bid.
Adoption Costs versus Value Proposition
One last item to think about on this topic is the business analysis hurdle that firms go through prior to adding a new business line. Unfortunately the TBA margin value proposition for most, if not all firms is a negative return. Most OTC market standards have the overseers make recommendations but it is left up to trade counterparties to make the final decision on these matters when they transact with each other. In the case of TBA margining, there really is no option. Sell-side firms are being told that they must adopt the measure and given the bi-lateral nature of margining and the fact that firms risk being shut out of the market, buy-side firms will have to sink costs and add staff, systems and the risk controls involved in TBA margining.
In conclusion, there is no doubt that posting bi-lateral margin on open, forward settling TBA, SPT, CMO and ARM transactions will mitigate systemic risks should a dealer go bust.
And that said, two interesting questions linger in this authors mind and that remain to be seen. First, how much risk return (a.k.a. mitigation) will the global financial system really see versus the associated costs for adding this business line? And two, will the fairly aggressive implementation time constraints really result in a noticeable but temporary or permanent down tick in market participants?