MBS CLOSE: Long Weekend Ahead
AHHHH....the FN 4.5 fell off the map at the end of the day!!!!
HAHA...this joke never gets old :-D
DONT PANIC. TODAY IS NOTIFICATION DAY!!!
(dont panic about the 10 tick drop that occurred at 4:30....the previous 8 hours were real though)
The October FN 4.5 MBS coupon (chart above) has begun the settlement process.
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), 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 DATE (clever name huh?). This is very similar to how TSY futures contracts trade...with a few differences. The most important difference you should be aware of is the fact that MBS trading settles once a month. For instance we have been watching the October MBS coupon trade since September 10. As of Tuesday morning we will be watching the November FN 4.5 MBS coupon until November 9.
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. The MBS buyer then reviews the pool information to ensure that the seller is delivering 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 trade).
But why do prices seemingly fall when the current delivery month comes to an end on notification day?
Prices dont really fall...we just start watching next month's coupon because the last month's coupon is settling. The forward month coupon price remains the same...SEEE
I KNOW I KNOW...in your eyes prices are lower. Let me explain the reason why prices fall when we start watching the forward month coupon.
The main reason behind the price "DROP" is lost "time value of money".
Interest rates can be thought of in three ways..
1. Required Rate of Return: this is the minimum amount of return an investor is willing to receive when making an investment.
2. 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.
3. 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.
That said...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.
Now to relate this concept to the MBS market...if you buy the October FN 4.5 coupon, then your returns will begin accruing on October 1. If you buy the November coupon...your returns dont start accruing until November1
You are missing out on accrued interest! To compensate for the lost Time Value of Money you demand a higher yield....which means lower MBS price.
Did a light bulb just go off in your head?
Plain and Simple: If you own the October MBS coupon, then you are entitled to the coupon clips (income) paid in October..this income is generated from the underlying loan's principal and interest (passed through from borrower to MBS investor). If you decided to wait until November to buy an MBS coupon...then you have to wait until November 1 to start accruing income....so to compensate for the lost "time value of money" ..investors demand higher yields, which is why prices fall when delivery rolls forward to the next month.
And yes...there is the potential for rate sheets to reflect this price drop...but it theoretically shouldnt hurt pricing in the morning as most lenders have already accounted for "the drop".
Learn something new everyday and let your brain appreciate with time! - ME
SIFMA says we dont have to work on Monday....so we'll use that day to focus on what lies ahead for the rates market.
ENJOY THE THREE DAY WEEKEND