8 TBA Trading and Liquidity in the Agency MBS Market
3.5 Hedging and Financing Mortgages
through TBAs
TBAs also facilitate hedging and funding by allowing lenders
to prearrange prices for mortgages that they are still in the
process of originating, thereby hedging their exposure to
interest rate risk. In the United States, lenders frequently give
successful mortgage applicants the option to lock in a
mortgage rate for a period of thirty to ninety days. Lenders are
exposed to the risk that the market price will fluctuate in the
period from the time the rate lock is set to when the loan is
eventually sold in the secondary market. The ability to sell
mortgages forward through the TBA market hedges
originators against this risk. It is important for originators to
offer applicants fixed-rate loan terms before a mortgage
actually closes, which greatly facilitates the final negotiations
of house purchases and the overall viability of the thirty-year
fixed-rate mortgage as a business line.
Although this price risk could also be hedged with other
instruments, TBAs provide superior hedging benefits because
of their lower basis risk. Confirming this view, Atanasov and
Merrick (2012) find that prices of specified pool trades for
TBA-deliverable securities co-move almost perfectly with
prices for the corresponding TBA contract, except for trades
small (below $25,000) in size. Price movements of Treasury
futures, in contrast, can diverge significantly from those of
MBS because of movements in prepayment risk premia or
changes in relative supply. Mortgage option contracts are more
expensive than TBAs, less liquid, and only available for short
time horizons (these options are instead used to hedge against
variation in the fraction of rate locks subsequently utilized by
borrowers). While a mortgage futures contract might provide
some of the benefits of TBAs, historical attempts to establish a
mortgage futures contract in the United States have been
unsuccessful (see Nothaft, Lekkas, and Wang [1995] and
Johnston and McConnell [1989]). The hedging benefits
provided by TBAs will likely be passed on to mortgage
borrowers in the form of lower interest rates because of
competition among lenders.
TBA trading has also led to the development of a funding
and hedging mechanism unique to agency MBS: the dollar roll.
A dollar roll is simply the combination of one TBA trade with a
simultaneous and offsetting TBA trade settling on a different date.
TBA trading has . . . led to the development
of a funding and hedging mechanism
unique to agency MBS: the dollar roll.
This mechanism allows investors and market makers great
flexibility in adjusting their positions for either economic or
operational reasons. For example, an investor who has purchased
a TBA, but faces operational concerns about receiving delivery as
scheduled, could sell an offsetting TBA on that date and
simultaneously buy another TBA due one month later, effectively
avoiding the operational issue but retaining his economic
exposure. An investor could also obtain what amounts to a short-
term loan at a favorable rate by selling a TBA for one date and
buying another TBA for a later one. For market makers on the
other side of such trades, dollar rolls provide an efficient means for
maintaining a neutral position while providing liquidity.
A dollar roll transaction is similar to a repurchase
agreement (repo), in which two parties simultaneously agree
to exchange a security for cash in the near term and to reverse
the exchange at a later date.
22
Dollar rolls facilitate financing
by providing an alternative and cheaper financing vehicle to the
MBS repo, drawing in market participants whose preferences
are better suited to the idiosyncrasies of the dollar roll.
23
Note
that dollar rolls also simplify the adjustment of originators’,
servicers’, and other market participants’ TBA commitments
and hedges by reducing not only the total cost but also the cash
outlay associated with hedging, because the cost of a dollar roll
is only the difference between the prices of two different TBAs.
The ability to lock in TBA forward prices may be
particularly useful for smaller originators, who have less access
to complex risk management tools that would otherwise be
needed to hedge price risk. Some smaller banks already can and
do engage in “correspondent” relationships, whereby they sell
some or all of their whole loans to larger banks, which then
arrange securitization and may be able to negotiate more
attractive prices from GSEs. In the absence of a TBA market,
this practice might become more widespread. A further
consequence could be an increase in the overall share of
mortgages originated by the largest commercial banks.
24
22
As with a repurchase agreement, these are two separate purchase/sale
transactions, but the economic effect is equivalent to secured borrowing/
lending. Since the initial exchange of cash and security is reversed, the
economic impact is measured by the difference in the prices of the two
transactions and the allocation of principal and interest payments over the
term of the dollar roll. One fundamental difference is that while the second leg
in a repo (reversing the original exchange) requires the return of the original
security, in a dollar roll only a “substantially similar” security needs to be
delivered, consistent with a definition of substantially similar directly tied to
SIFMA’s “good delivery” guidelines for TBAs.
23
For instance, dollar rolls can be used to transfer prepayment risk, since,
unlike MBS repos, dollar rolls transfer rights to principal and interest payments
over the term of the transaction.
24
Currently, the four largest commercial banks originate more than half of all
mortgages (source: www.mortgagestats.com), a sharp increase compared with
the banks’ market share before the onset of the financial crisis.