The move to daily margining for the US Mortgage-backed trading market requires heavy investment in resources and technology. Alpha Financial Software’s Joseph Kohanik explains the emerging best practices, such as the use of trade assignments, for firms needing to improve their management of margining in this newly evolving MBS market.
With the new margining rules on the horizon and the days of the “Wild West” quickly falling into hindsight, there are some positives that will certainly come from daily margining of U.S. Mortgage-Backed Trading: higher employment, lots of consulting fees and more focus on the systemic risks that mortgages bring with them.
I do jest, but the first two are a reality at many firms who are going from no margining to daily margin processing. These firms require a pretty significant investment in human capital and systems and more importantly financial capital during the next 2 years if they want to trade beyond 2016, when I would expect the new margining rules take effect.
People are predicting that the market will suffer, post enactment of the new rules, but this is hard to believe when one looks at such facts as market presence; U.S. mortgages carry a hefty, 30-35% weighting in both domestic and global bond performance benchmarks. As passive investment and index investing continues to grow, via ETF’s, so will the asset allocation towards mortgages. In addition, at 6-7 trillion dollars, U.S. mortgages provide a much safer asset class when one looks across the globe of investible pay-down fixed income assets.
As TBA margining requires upfront, initial margin, as well as daily mark-to-market, investors should always look to clean up any and all offsetting trades in order to decrease the amount of cash or assets they have to pledge as collateral. Now that the market thinks about how to manage their business in the new margining world, there are a number of operational best practices that investors should consider. Let’s look at how firms gain exposure to the U.S. Agency MBS market to help identify two best practices that firms should employ in today’s market.
GAINING EXPOSURE TO THE U.S. AGENCY MBS MARKET
Investors primarily gain exposure to the U.S. mortgage market by owning either specific mortgage pools or buy owning mortgage TBA’s (“To-be-Announced”) which are forward settlement mortgages. There are other ways to gain exposure such as ETF’s and active or passive bond funds but the focus of this article looks at the overwhelming majority of investors and how they invest. TBA’s can be bought/sold with settlements 30, 60, 90 days into the future. And, to fully settle a TBA trade the seller must deliver to the buyer specific mortgage pools that meet “good delivery” guidelines. TBA’s work in a similar way that “deliverable futures” work in the U.S. Treasury market; they signify a future settled position in specific mortgage pools.
To facilitate “good delivery” settlement on a 10 million dollar TBA trade requires clearance automation and a pool delivery optimization engine as many pools will likely be combined together to settle the trade. Many firms use Excel spreadsheets to manage “good delivery” rules. However, in a world that thrives on cut-off times and with managers who trade ever closer to these time limits, the need for automated systems that can optimize millions in mortgage pools in milliseconds is a must have.
MANAGING YOUR MONTHLY ROLLS
A common play in the market is to “roll” TBA trades from month to month thereby maintaining a constant hedge against a portfolio of mortgage pools or maintaining a constant exposure to mortgages. To roll TBA trades means closing out a current month and opening a trade in a future month. Unfortunately, in today’s world, and with many firms not having the aforementioned systems, investors might be forced to roll trades with the same dealer on the opening hedge. Being forced to roll with the same dealer every month, in today’s world, can easily result in firms not getting best-execution for their clients. The reason is simple. Dealers are sophisticated; if they know their counterparty doesn’t have the capacity to perform good delivery optimization, then they know that they might not have to work as hard to get the roll trade done. On the flip side, if a dealer is aware that their counterparty has an MBS clearance system and the capacity to go in another direction then they will have to be competitive to win the roll business.
TRADE ASSIGNMENTS NEARLY ZERO OUT YOUR RISK
As indicated earlier, a successful mortgage investor needs system capacity and business logic required to be a sophisticated investor. In addition to this, investors need to use all of the tools available to them in their tool kit. Perhaps one of the most important best practices is the use of trade assignments. They allow firms to offset risks very efficiently in a margining world, as they ultimately result in a single pair-off and a wire for the profits/losses.
When trading for best-execution, which we know should always be the case, investors will no doubt wind up with scenarios where they are buying a TBA from one dealer and selling the same TBA to another dealer, all for the same market-wide settlement date. Given this scenario, many firms think that they need to take delivery of pools on their buy trade and deliver out pools to settle their sell TBA, which is high risk process. This is not so! The costs to take in and deliver out pools can be expensive should a fail-to-deliver occur. These operational and potential fail-to-deliver costs can be eliminated and counterparty risks mitigated by using the standard SIFMA Trade Assignment Agreement. This agreement allows an investor to legally transfer their sell TBA trade obligations from the sell counterparty to the buy trade counterparty. This results in the investor having a buy and sell TBA that can be paired-off and the profits/losses wired to the buy counterparty.
As discussed, no pools have to be delivered in this scenario. However, in order to use the Trade Assignment Agreement requires the approval of all three counterparty’s involved. To manually complete this 5 page legal agreement and faxing it to get the necessary counterparty approvals can be an operational bottleneck if, once again, the investor does not have the systems and automation to expedite the delivery of the agreement. There is an industry-wide cut-off time for receipt of the agreement by the counterparty’s. Traders often push these time limits in search of higher profits. Prior to the 2008 crisis, dealers were very lax on the cut-off time. Since the rule changes post the 2008 crisis and the elimination of a two day grace period, dealers are now holding firm to the cut-off times. This means that investors must have the system capacity to instantaneously prepare and send out the Trade Assignment Agreement to counterparty’s.
TRADE ASSIGNMENTS: A BEST PRACTICE IN THE MARGIN WORLD
By using Trade Assignments to offset trading risks when they present themselves, whether it be “rolling” to a new dealer or a simple buy /sell offset, firms will further mitigate risk. There will always be the need to move pool inventory and in a margining world those firms, such as originators, may not need to post initial margin. But for those investors in the market, who will post initial margin, the Trade Assignment brings a lot of risk mitigation that will have a positive impact on daily margining movements. As firms invest in margining over the next two years let’s just hope that the trade assignment gets its due consideration on the project plan of those firms who don’t employ them today.