Question

 Describe the TBA market in agency pass-through securities in detail. When does settlement occur relative to trade execution? What are the main benefits of the TBA market?

 Describe the adverse selection problem in the context of TBA trading.

 Describe the unintended consequences of Federal Reserve intervention in the agency TBA market.

Answer 1

TBA MARKET IN AGENCY PASS THROUGH SECURITIES IN DETAIL

Pass-through securities issued by Freddie Mac, Fannie Mae, and Ginnie Mae trade in the TBA market, and the term TBA is derived from the fact that the actual mortgage-backed security that will be delivered to fulfill a TBA trade is not designated at the time the trade is made. The securities are announced 48 hours prior to the established trade settlement date.

A TBA serves as a contract to purchase or sell an MBS on a specific date, but it does not include information regarding the pool number, number of pools, or the exact amount that will be included in the transaction. An MBS is a bond that is secured, or backed, by mortgage loans. Loans with similar traits are grouped together to form a pool, and that pool is subsequently sold to stand as collateral for the associated MBS.

Interest and principal payments are issued to investors at a rate based on the principal and interest payments made by the borrowers of the associated mortgages. Investors receive interest payments on a monthly basis instead of semiannually.

This is because the TBA market assumes MBS pools to be relatively interchangeable. The TBA process increases the overall liquidity of the MBS market by taking thousands of different MBSs with different characteristics and trading them through a handful of contracts. The buyers and sellers of TBA trades agree on these parameters: issuer, maturity, coupon, price, par amount, and settlement date.

When does settlement occur relative to trade execution?

Each type of agency pass-through security is given a trade settlement date for each month. Trade counterparties are required to exchange pool information by 3 p.m. (EST), 48 hours prior to the established settlement date. Trades are allocated in $1 million lots.

The main benefits of the TBA market

A TBA is a good initial guide to a trade, but since it doesn't all the details of a trade, it is best left to professionals who understand the nuances of TBA trades.

The liquidity of the TBA market raises MBS prices and lowers mortgage interest rates. This analysis makes use of the fact that not all agency mortgages and MBS are TBA-eligible. Based on this suggestive evidence, the liquidity benefit of TBA eligibility for agency MBS yields and mortgage interest rates is of the order of 10 to 25 basis points, as observed in 2009 and 2010.

The TBA market currently serves a valuable and important role in the mortgage finance system. The authors suggest that “evaluations or proposed reforms to U.S. housing finance should take into account potential effects of those reforms on the operation of the TBA market and its liquidity.” To this end, the authors review the prospects for the TBA market amid the housing finance reform discussion.

The adverse selection problem in the context of TBA trading.

Because of the incentives associated with cheapest-to-deliver pricing, not all eligible MBS pools actually trade on a TBA basis. Higher-value pools (those with the most advantageous prepayment characteristics from an investor’s point of view) can command a higher price in the less liquid specified pool market.19 Specified pool trading, as well as the use of “stips,” is generally more common for seasoned pools than for newly issued pools, reflecting their lower prepayment risk and therefore higher value. However, specified pools are much less liquid, largely because of the much greater fragmentation of the market.20 According to conversations with market participants, a significant volume of physical delivery of securities occurs through the TBA market because, for many securities, the liquidity value of TBA trading generally exceeds any adverseselection discount implied by cheapest-to-deliver pricing. In part, this is because the significant level of homogeneity in the underwriting and pooling process constrains the variation in value among securities deliverable into a given TBA contract. Paradoxically, the limits on information disclosure inherent in the TBA market seem to actually increase the market’s liquidity by creating fungibility across securities and reducing information acquisition costs for buyers of MBS. A similar argument explains why DeBeers diamond auctions involve selling pools of diamonds in unmarked bags that cannot be inspected by potential buyers. More generally, the idea that limited information can reduce adverse selection and increase trade is known to economists as the “Hirshleifer paradox”.

The unintended consequences of Federal Reserve intervention in the agency TBA market

1. Issuance of high-balance MBS pools
2. Secondary market pricing of high-balance MBS pools
3. Effects on mortgage pricing
4. Effects on the quantity of credit