MBS CLOSE: EXPLAINING THE ROLL
MBS patiently outperformed TSYs today while equity market "bottom pickers" placed their bets that the worst of the financial and economic crisis is behind us.
MARCH FN30 (LAST DAY)_____________________
FN 4.0 -------->>>> -0-07 to 98-29 from 99-04
FN 4.5 -------->>>> -0-04 to 101-00 from 101-04
FN 5.0 -------->>>> -0-03 to 102-11 from 102-14
FN 5.5 -------->>>> +0-02 to 103-01 from 102-29
FN 6.0 -------->>>> +0-04 to 103-19 from 103-15
APRIL FN30_______________
FN 4.0 -------->>>> 98-19
FN 4.5 -------->>>> 100-21
FN 5.0 -------->>>> 101-30
FN 5.5 -------->>>> 102-20
FN 6.0 -------->>>> 103-09
NOTICE "THE DROP" IS ABOUT 10 TICKS ACROSS THE STACK....
MARCH GN30________________________________
GN 4.0 -------->>>> -0-09 to 99-00 from 99-09
GN 4.5 -------->>>> -0-05 to 101-09 from 101-14
GN 5.0 -------->>>> -0-02 to 102-23 from 102-25
GN 5.5 -------->>>> +0-04 to 103-11 from 103-07
GN 6.0 -------->>>> +0-03 to 103-21 from 103-18
In average trading volume the MBS coupon stack managed to hold its ground against the rapidly selling.. supply heavy....TSY yield curve. MBS managed to close 10-16 ticks tighter to TSYs. The bad news: cheaper prices for premium MBS (fuller coupons) lured a few "up in coupon" risk takers from their positions in "rate sheet supportive"/prepay protected MBS coupons. News appears to have spread that REFI PLUS and DU REFI PLUS (and Freddie version) wont take effect on MBS immediately. For now we will treat this behavior as a short term "opportunistic" trading strategy. But we will continue to monitor the momentum of "up in coupon".
Today is Class A Notification Day. This means effective today we start watching April FN/FRE coupons. (GN Coupons = Class C). Here is the SIFMA Settlement Calendar if you would like to print....LINK
Ever Wonder Why the MBS Price Drops on Notification Day?
Because we are switching from March Delivery to April Delivery and MBS investors who didnt buy March coupons will miss out on March cash flows!!!
Plain and Simple: The MBS "holder of record" gets to keep the income earned from the MBS for the month they own it. So if you buy MBS for March delivery you are entitled to the income earned from March coupon payments and March principal paydowns. If you sell your March coupon you lose that income. Here is where the term "the roll" comes into play.
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.
Well if you sell your March coupons on March settlemnt date you lose the income you would have earned from holding them until April settlement. To compensate you for that loss of income the "roll buyer" agrees to sell you back the a pool of very similiar loans for a cheaper price. That cheaper price is where the term "the drop" is derived. The drop is the difference between the price of this months delivery of MBS vs. taking delivery one month later.
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!
Stocks unexpectedly rallied around the world today....
Everyone hurry get all your money and run to the stock market. The world is saved THE WORLD IS SAVED!!!!!!
Wait wait...why are we running to invest again?Who saved the world? Citibank?
(please note sarcasm)
I would love to hear what you think about the stock market rally today....