Today is Class A Notification Day in the TBA Secondary Mortgage Market
The April FN 4.5 MBS coupon has now begun the settlement process. Before the end of the day, the FN 4.5 price is going to fall from where it is currently priced at 100-02 down to 99-21.
The MBS coupons that determine your rate sheet pricing are traded in the TBA MBS market....
TBA = To be Announced
In the TBA MBS market, at the time a trade is made, buyers and sellers agree to a few specific terms like what coupon, the issuing agency (Fannie, Freddie, Ginnie), size of trade, and a buy/sell price....the actual pools of loans are NOT exchanged at the time of this commitment. Instead, the MBS buyer and the seller make an agreement to complete the transaction at a later date. In the MBS market this date is pre-determined; it is called SETTLEMENT DAY (clever name huh?).
Agency MBS trading settles once a month. We have been watching the April FN30 4.5 MBS coupon trade since Tuesday March 9. As of Monday morning, we will be watching the May FN30 4.5 MBS coupon until Tuesday May 11, 2010.
We can actually watch forward pricing as much as three months ahead.
Anyway...two days before the pre-scheduled settlement date, the MBS seller "notifies" the MBS buyer of the specific pools that they will deliver to satisfy the previously agreed upon terms of the trade.
This is Fannie Mae's guidance:
Forty-eight hours prior to settlement, pool information must be communicated to the Capital Markets Sales Desk's back office by phone (202-752-5384), facsimile (202-752-3439), or via EPN transmission. Delivery of pool information must take place by 3:00 p.m. eastern time. It is advisable that pool information is communicated early as phone lines, fax machines, and the EPN queues are extremely taxed as the 3:00 p.m. deadline approaches. If the transmission does not occur by 3:00 p.m., one day's fail will be incurred, despite the fact the information is residing in queue.
Then the MBS buyer reviews the pool information to ensure the seller has delivered loans that meet the agreed upon terms. 48 hours later, after being deemed to within "Good Delivery" guidelines, pool purchase funds are wired and the trade is complete (it goes deeper...this is the outline).
BUT WHY DO PRICES SEEM TO FALL WHEN WE ROLL FROM FRONT MONTH TO BACK MONTH COUPONS?
Today the front month is the April coupon. The back month is the May coupon.
Prices don't really fall though. We just start watching next month's MBS coupon because last month's coupon has just entered into the settlement process. The back month coupon price remains the same!
Below is the current May settlement FN 4.5 MBS coupon. It's bid at 99-21. This is where prices will "seem" to fall later this afternoon.
The main reason behind the price "DROP" is lost "time value of money".
Interest rates can be thought of in three ways..
- Required Rate of Return: this is the minimum amount of return an investor is willing to receive when making an investment.
- Discount Rate: the rate used to determine the present value of future cash flows. When you loan someone money with the intention of being paid back in the future, you must place a value on how much of a premium you are losing by not spending that money right now. The discount rate is essentially how much you are charging to delay repayment until a future date.
- Opportunity Cost: the value an investor passes up when choosing an alternate investment. You must earn enough interest when you loan someone money to compensate for the loss of income that you could have been earning by investing elsewhere.
Would you rather have $1.00 today or $1.00 tomorrow?
You would rather have $1.00 today! If you have $1.00 today you can invest it today...the fact you are investing today vs. tomorrow implies you are giving the asset more time to appreciate, more time to accumulate interest earned.
To relate this concept to the MBS market---if you buy the April FN 4.5 coupon, then your returns will begin accruing on April 1. If you buy the May coupon---your returns don't start accruing until May 1. That means you would have to wait 21 days for your money to start working for you. Investing now puts money to work now, or in today's case, on April 1.
Starting on Monday, because the April coupon has already entered into settlement, MBS investors will have to wait until May 1 to see their funds start working. To compensate for the lost Time Value of Money, investors demand higher MBS yields. This is accomplished by lowering back month bid prices.
to compensate for the lost Time Value of Money you demand a higher yield....which means lower MBS price.
Note: to be clear, the previous owner has rights to the income (accrued interest) earned from while they owned the coupon. The price you pay to purchase the back month coupon includes the income the current owner has accrued while they owned the coupon. The buyer recovers the added premium when the coupon payment is deposited in their account. This is called the 'clean price'...its the same way Treasuries trade.
Plain and Simple: If you own the April MBS coupon, then you are entitled to the coupon clips (income) paid in April. If you decided to wait and buy the May MBS coupon...then you have to wait until May for your investment to start earning interest. To compensate for the lost "time value of money", investors demand higher yields, which is why prices fall when delivery rolls from front month to back month.
This explains why 60 and 90 day locks are more expensive. The longer the lock commitment period, the more it costs the lender to hedge interest-rate volatility and fall out risk.