Overall it hasnt been that bad of an afternoon. The 30 yr bond auction was not a failure but we wouldnt call it a success either. Since the market is just starting to warm up to longer duration debt instruments (long life, maturity longer), we are not surprised that the long bond was met with apathetic demand. The general lackluster sentiment towards the 30 yr bond did however have dramatic steepening effect on the yield curve. The 2s vs. 30s measure of steepness is at 335bps, 8 bps higher than this morning as the 30 yr bond is -1-20 in price...thats 52/32 lower!!!The 2s vs. 10s part of the curve is 6 bps steeper.
Check out how the 10 yr has fluctuated with the S&P since 1pm....its been a choppy afternoon,but both the 10 yr and the S&P are undecidedly stuck in a choppy channel.The S&P has bounced between 888 and 881 while the 10 yr note has fluctuated between 3.42% and 3.36%. That said..yes the 10 yr has lost some momentum from yesterday's knee jerk move lower.
What do I mean?
I am saying the 10 yr made a higher low yield and a higher high yield today. Thats a hit to momentum...and although this is not enough to say that the bulls have lost control over the yield curve, it is likely enough to say that we should continue to bounce around this range for the time being before moving lower....well...a continued TSY rally is dependent upon weakness in stocks too.....
Below is a chart of the S&P 500 overlaid with the 20 day moving average and the 200 day moving average. The S&P did it best to stay above these moving averages all day, however heading into the close the S&P is showing signs of falling below these resistance levels.Hmm range bound?
FURTHERMORE...volume is super low on the stock market! Moves to the upside have not been supported by any strength. This low volume could be a function of vacations on Wall Street, but it could also be a function of the marketplace waiting to see how firms (banks specifically) are going to make money in the future...earnings reports!!!
Plain and Simple: the market is stuck again...stocks are range bound after being oversold (short term) and benchmark TSYs have corrected from being a bit overbought/profit taking...both sides of the street are unwilling to make a move to in either direction. Once again...we are awaiting guidance. Once again...we are RANGE BOUND!!!
Now onto MBS.
Prices of the FN 4.5 have stopped falling at 100-14 and are now on the rise again as the 10 yr yield moves back towards 3.38%. At the moment the FN 4.5 is trading at 100-21, down 0-10 on the day while the 10 yr TSY note is down 0-22.
We arent complaining...especially when you consider that late this afternoon there was a large block of loans sitting on the market, waiting for bids...this explains why yield spreads gapped out a bit around 2:30pm. Gapped out means TSYs started to outperform FN 4.5s...yield spreads got wider! This occurred because an originator decided it was time to dump some supply of MBS on the market. All this means is someone was locking in a block of their loans, just like you lock in your loans (MORE BELOW). When supply > demand...prices must fall to account for excess supply. Although the prices (offers) were relatively high compared to what we've been use to over the past month, this was kinda bad timing as many accounts are in "settlement day" mode...HUH? YES...REMEMBER THIS MORNING WE REMINDED THAT TODAY IS NOTIFICATION DAY????
(btw that was more of a transition to next topic: the Fed and Servicers absorbed that supply easily but did let offer priceS fall a few ticks before doing so)
What Happens on Notification Day?
The MBS coupons that determine your rate sheet pricing are traded in the TBA MBS market...TBA = To be Announced. In the TBA market, at the time of a trade, buyers and seller agree to only a few specific terms, like what coupon, the issuing agency (Fannie or Freddie), and a buy/sell price....the actual pools of loans that will be bought and sold are not disclosed at the time of this agreement. Instead, two days before the pre-scheduled settlement date (determined by SIFMA), the MBS seller "notifies" the MBS buyer of the specific pools that they will deliver to satisfy the previously agreed upon trade. The MBS buyer then reviews the pool information to ensure that the seller is delivering pools of loans that meet the agreed upon terms (which were determined at the time of the trade). Then two days later, on settlement date, funds are wired and the trade is complete (it goes deeper...this is the outline of the trading process).
The TBA trading mechanism plays a very important role in the generation of mortgage rates. The TBA market allows originators to make "forward commitments" before the loans in their pipeline are actually closed...just like loan officers lock in interest rates before the loan oes to closin. For both the mortgage bank and the loan officer, this function serves as a hedge. It allows them to protect their pipelines from interest rate risk (rates getting higher and their loans not being worth as much). If mortgage bankers were forced to lock in their rates after closing...they would likely add in a large "interest rate risk" premium to rate sheets in an effort to protect themselves from shifts in the yield curve.
Plain and Simple: Without the TBA market mechanism...mortgage rates would be much higher!!!
On notification day, at the end of the trading session prices seemingly DROP 10-12 ticks (usually). This causes some chaos for loan officers who are watching MBS pricing because they view this as an actual drop in prices. Its not. Its really just rolling forward the current MBS coupon to the next month's delivery date!
The main reason behind the price "DROP" has to do with the "time value of money". The longer you own the cash flows...the more time the asset has to appreciate.
Plain and Simple: If you own the July MBS coupon, then you are entitled to the coupon clips (income)...this income is generated from the underlying loan's principal and interest (passed through from borrower to MBS investor). Well...if an MBS investor decided to wait until August to buy an MBS coupon...that investor is deciding to forego the cash flows they could have been collecting from owning the July MBS coupon. So to compensate for the lost "time value of money" generated income...prices are adjusted when the delivery month rolls over.
What Determines "THE DROP"?
Whether or not it is worth owning the July coupon vs. the August coupon is predicated off of several complicated factors...expected prepay speeds vs. actual prepay speeds, market supply/demand (need to cover short/dont need to cover short position), and financing costs. Market participants determine the amount of the drop the same way they determine cash market prices...TRADING. MBS investors actually TRADE THE ROLL!
Longstanding readers have read this, hopefully it makes more sense every time you read it! New readers: enjoy
For various reasons...you can choose to lend your pool of MBS to someone else who needs it more than you do at settlement. When you agree to loan another MBS investor your pool of loans they must agree to sell you back a similar pool of MBS on the next month's settlement date.
Here is an example of how it works...
Say hello to Dealer A and Trader B. Dealer A owns a pool of MBS. Trader B needs a pool of MBS right now.
Trader B calls up Dealer A and says "hey I really need those MBS you own, can I borrow them from you? I promise to give them back to you next month."
Dealer A says "yeah that's cool but I need some form of collateral just in case you don't give them back. I prefer cold hard cash and you aren't the first person to call asking to borrow my pool of MBS so how about you pay market price for the current TBA delivery month? And another thing I will only agree to let you borrow my MBS if you promise to sell them back to me next month on settlement date."
Trader B says "Great! I only need to borrow your pool of MBS for one month anyway. Everything sounds good I only have one question...At what price do you expect to purchase them back?"
Dealer A says "Well, considering that while you own my pool of MBS I am missing out on all the coupon payment cash flows....I am going to need to be compensated for that loss of income."
Trader B says "Ok that is fair. Don't forget you can always take the money I am giving you as loan collateral and re-invest it in some other short term liquid trade (like Fed Funds). Just be sure to put that money in a very liquid market so you can repurchase the pool of MBS back from me next month"
Dealer A says " yeah you're right I can reinvest the funds you provide as collateral, but I am also losing out on the scheduled and unscheduled prepayment cash flows that we have forecasted to occur in the next 30 days. So we need to take that possible loss of income into account before deciding on a repurchase price. Ok....after doing my breakeven calculations I will only agree to this transaction if you are willing to sell me back my pool of MBS for 10 ticks less than what you are paying me today. It's only fair to compensate me for my loss of income over the next month. Plus I get the feeling you really need a pool of MBS right now"
Trader B says "Ok fine I can't get anyone else to lend me the pool of MBS and I need to cover a short position. I agree but there is one problem. I can't sell you back the exact pool of mortgages that you are lending me...I can promise to return a replica of your current pool though. Is that ok?
Dealer A says "I don't know...my pool of loans in performing. Well you are compensating me nicely.....ok fair enough but you have to return a pool of substantially identical securities...no funny business here I want loans issued by the same agency, with the same maturity and identical coupon rates"
Trader B replies "ok you have a deal. Sell me your pool of MBS today and I agree to sell you back a pool of "substantially identical securities" next month on the settlement date. In order to compensate you for lost coupon payment cash flows I agree to offer you a cheaper price when I sell you a similar pool of MBS next month. Talk to you on notification day. Later Dealer A....oh haha before I forget....our firm's team plays your firm's team tonight....our DH played for the Mets...good luck buddy"
Dealer A responds quickly "The Mets are garbage, we ain't scared sonny."
Click.
Trader B says "hello heeello aah he got me!"
There you have it. The dollar roll explained!
Currently the "drop" is 11 ticks (11/32). So at 430 the price of the FN 4.5 will fall 11-ticks.
In the above MBS chart I illustrated the "DROP", at that time it was only 9 ticks. Looks like the roll has gotten weaker as the day has progressed. Currently the July FN 4.5 is trading at 100-19 and the FN 4.5 August MBS coupon is trading at 100-08, if the market closed right now, thats where we would open tomorrow...dont panic, its not a sell off!!!
Phew. Long Post!
What are we waiting for? Confirmation...READ MBS MORNING.
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