The Drop: Why Longer Lock Periods Cost More

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July delivery Fannie and Freddie 30 year fixed MBS coupon have begun the settlement process. It will soon seem like MBS prices just plummeted.

WHY???

Today is Class A Notification Day in the secondary mortgage market.  "Notification" is part of the "allocations" process, in which pools are delivered against TBA trades at settlement. Class A MBS coupons consist of Fannie Mae and Freddie Mac 30 year pass-throughs.  (Class B is comprised of all 15-year fixed pools; class C consists of 30-year Ginnie Is and IIs.)  The MBS coupons that determine rate sheet pricing are traded in the TBA MBS market.   Settlement days in each month are determined by SIFMA.

TBA = To be Announced.
In the TBA 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  the trade price....the actual pools of loans are NOT allocated 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 .   These dates are also known as "good-day settlement".

Agency TBA MBS trades typically settle 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).

WHY DO PRICES SEEM TO FALL WHEN WE "ROLL"?

Pipeline hedgers are able to open MBS trades for multiple settlement months. There is a front-month settlement coupon and a back-month settlement coupon. Today the front month coupon is for July loan delivery and the back month is for August loan delivery. Tomorrow, because the monthly settlement process has begun,  front month delivery will be for August delivery and back month will become September. (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 selloff though. The price decline reflects the fact that  the front month is changing.  This is because the front month coupon has just begun the settlement process and the back month has about 30 more days until it settles.   The reason that prices for the different months are different is because the economics are different.  Buying for front-month settlement means that the investor owns and receives the principal and interest cash flows for that month.  Investors that buy for the back month forgo those net benefits; therefore the back month price is generally lower.  (The difference between the two months is called "The Drop.")  This is discussed in more depth below.

Below is the current July settlement FNCL 4.0 MBS coupon. It's bid at 101-02. Before the day is done we will roll to August delivery and the price of the front-month coupon price will seem to fall to 100-24.

Why 100-24? That's where the August delivery FNCL 4.0 is currently bid. This is where prices will seem to have fallen in the chart above when the roll is initiated on trading screens. The August coupon has actually been trading for two-months. "The Drop" is 10/32....

 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 July FNCL 4.0 coupon, then your returns will begin accruing on July 1. If you buy the August coupon---your returns don't start accruing until August 1. That means you would have to wait 19 days (from today) for your cash to begin accruing interest.  Investing now, before the roll,  puts money to work now, or in today's case, on July 1.

Starting tomorrow, because the July coupon has already entered into the settlement process, MBS investors will have to wait until August 1 to see their funds accrue coupon interest. 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  August delivery 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 July FNCL 4.0 MBS coupon, then you are entitled to the coupon clips (income) paid in July. If you decided to buy the August MBS coupon...then you have to wait until August 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 August coupon for several weeks now.   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 September delivery Class A MBS coupon in the next few days.