Previously we discussed the technical factor convexity.  Another set of technical factors that impact secondary managers are in the dollar roll market that we discussed a few weeks ago.  Dollar rolls (i.e., the price difference between the same security for different months’ delivery) are impacted by a number of factors.  First consider the different participants in the MBS markets.  Originators are generally selling their production for later months, given the factor that rate locks are taken under the understanding that the loans will fund at some point in the future.  That means that there is systemic selling pressure in the later (or “back”) months.  

Alternatively, some investors (such as banks) want to buy MBS for early settlement, since they can only begin to accrue coupon earnings once they own settled securities.  Finally, CMO desks (i.e., the units in broker/dealers that structure and market agency CMOs) have a structural need to buy various types of agency passthroughs for current-month settlement in order to settle their deals.  (That’s why CMO traders refer to passthrough pools as “collateral;” to them, they’re just fodder for deals.)

The combined impact of back-end selling and early-month demand means that dollar roll levels are often rich (or “special”) to where they should trade based on fundamental factors such as funding rates and short-term prepayment speeds.  The specialness of rolls is often exacerbated during periods of heavy issuance of MBS and/or CMOs.  Investors that have the option of buying front- or back-month settlement (such as money managers) can often take advantage of dollar roll specials to effectively gain cheap financing for their MBS holdings.  (I’ve had investors tell me that dollar-roll levels were the single biggest factor in choosing what MBS coupons to hold.)

The other factor impacting rolls, which is important to secondary managers, is the fact that rolls far out in settlement often trade erratically.  Broker screens often will show three delivery months, i.e., the current month, plus the next two back months.  That means that up until notification day, the current month and the next two months will be on the screen.  For example, levels for February, March, and April were shown as a delivery month until after last Thursday (2/9); after that, February was removed and May was added.  Prices for May then moved roughly back in line with other months; April/May rolls went from trading at around 14/32s to around 10/32s.

This means that secondary managers that sold TBAs for May settlement simply because they had a lot of long-term locks in their pipelines traded inefficiently.  It would have been much better for them to have continued to sell April TBAs until May actually were added to broker and TradeWeb screens.  At that point, they should look at their pipelines and adjust their positions to account for their expected fundings for each month.   A healthy respect for the market’s technical conditions will often help lenders improve their hedging efficiency and secondary results.