Notification Day: Monthly Roll Already Accounted for in Loan Pricing

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February Fannie and Freddie 30 year fixed MBS coupon have begun the settlement process and it will soon look like MBS prices just plummeted (more than they already did today).

WHY???

Today is Class A Notification Day in the secondary mortgage market. Class A MBS coupons consist of Fannie Mae and Freddie Mac 30 year loan notes. The MBS coupons that determine 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.  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 THE FRONT MONTH TO BACK MONTH COUPON?

Today the front month is the February delivery coupon and the back month is the March delivery coupon. Tomorrow,  the front month delivery will become the March coupon and back month will become April delivery (BACK MONTH COUPONS GENERALLY DICTATE LOAN PRICING BUT FRONT MONTH COUPONS DO MORE THAN ENOUGH TO PROVIDE DIRECTIONAL GUIDANCE. SEE MORE BELOW)

Prices don't really "fall" like they would in a sell off though, the price decline reflects the fact that we're rolling from front month to back month because the front month coupon has just begun the settlement process and the back month has 30 days until it settles. 

Below is the current  February settlement FNCL 4.5 MBS coupon. It's bid at 100-14. Before the day ends we will roll to March delivery.

100-02 is where the March delivery FNCL 4.5 is currently bid. This is where prices will seem to have fallen in the chart above when the roll is initiated on trading screens.

We can actually watch forward pricing as much as three months ahead. See.....

 The main reason behind the price "DROP" is the 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.

LET ME POSE A QUESTION: 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 (ACCRUE).

To relate this concept to the MBS market---if you buy the February FNCL 4.5 coupon, then your returns will begin accruing on February 1. If you buy the March coupon---your returns don't start accruing until March 1. That means you would have to wait 20 days (from today) for your money to start working for you.  Investing now, before the roll,  puts money to work now, or in today's case, on February 1.

Starting tomorrow, because the February coupon has already entered into the settlement process, MBS investors will have to wait until March 1 to see their funds put to work. To compensate for the lost Time Value of Money, investors demand higher MBS yields. This lost time value of money is discounted via a lower back month coupon price (in this case the March FNCL 4.5 coupon).

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'...it's the same way Treasuries trade.

Plain and Simple:  If you own the February FNCL 4.5 MBS coupon, then you are entitled to the coupon clips (income) paid in February. If you decided to buy the March MBS coupon...then you have to wait until March  for your investment to start accruing 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. (not including any profit earned from price movement)

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.

HOW DOES THIS AFFECT LOAN PRICING?

You won't notice the effects tomorrow. Lenders have been building loan pricing based on the March coupon for several weeks already.   Lenders must roll earlier because secondary desks are lower in the MBS supply chain and need to deliver their closed loans to investors with enough time to allow for post-closing/pre-purchase review. I'll probably roll forward to the April delivery Class A MBS coupon in the next few days. If your rate sheets reflect a roll cost on that day, I will alert. Otherwise we've already absorbed it.....