Happy Notification Day.
We hope you've been around long enough to avoid this joke. If you havent...this chart will probably scare you...BOO!!!
OH NO MORTGAGE RATES ARE GOING THROUGH THE ROOF!!!
HAHA LMAO....
Im messing with you. Its notification day. Do not fret!
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EDUCATIONAL OPPORTUNITY
The MBS coupons that determine your 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), and a buy/sell price....the actual pools of loansare 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 determined by SIFMA....it is called SETTLEMENT DATE (clever name
huh?). This is very similar to how TSY futures contracts trade...with a few
differences. The most important difference you should be aware of is
the fact that MBS trading settles once a month. For instance we have
been watching the August MBS coupon trade since July 9. As of tomorrow
morning we will be watching the Sept FN 4.5 MBS coupon until Sept 10.
Anyway...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. The MBS buyer then reviews the pool information to ensure that the seller is delivering loans that meet the agreed upon terms (which were determined at the time of the trade). Then two days later, on settlement date, funds are wired and the trade is complete (it goes deeper...this is the outline of the trade).
Yay. But why do prices seemingly fall when the current delivery month comes to an end on notification day?
Prices dont really fall...we just start watching next month's coupon because last month's coupon is settling. The forward month coupon price remains the same...SEEEEEE:
I KNOW I KNOW...in your eyes prices are lower. Let me explain the reason why prices fall when we start watching the forward month coupon.
The main reason behind the price "DROP" is 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.
That said...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.
Now to relate this concept to the MBS market...if you buy the August FN 4.5 coupon, then your returns will begin accruing on August 1. If you buy the September coupon...your returns dont start accruing until Sept 1. You are missing out on accrued interest! To compensate for the lost Time Value of Money you demand a higher yield....which means lower MBS price.
Did a light bulb just go off in your head?
Plain and Simple: If you own the August MBS coupon, then you are entitled to the coupon clips (income) paid in August...this income is generated from the underlying loan's principal and interest (passed through from borrower to MBS investor). If you decided to wait until September to buy an MBS coupon...then you have to wait until September to start accruing income....so to compensate for the lost "time value of money" ..investors demand higher yields, which is why prices fall when delivery rolls forward to the next month.
And yes...there is the potential for rate sheets to reflect this price drop...but it theoretically shouldnt hurt pricing in the morning as most lenders have already accounted for "the drop".
END EDUCATIONAL MOMENT.
Learn something new everyday and let your brain appreciate with time! - ME
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Phew. Ok now to review today and discuss the day ahead....
Stocks moving lower led TSY traders to push futures prices higher heading into the 1pm auction. However as prices ticked up, market participants decided it was time to do some profit taking to remove the risks associated with a weak auction. Following position squaring markets went quiet...making for an illiquid trading environment as most had put themselves on the sidelines...watching and waiting. Then the auction results came...and they were good as Indirect bidders were awarded $23 billion...a record 62%.
Leading up to the auction...TSY futures appeared to have benefited from new money and SOME short covering...which, in the illiquid environment after the auction lead the market lower. However...buyers did return as prices fell, which eventually pushed bids back to the topside of the range (see chart below). In the meantime...some profit takers had done MBS dirty...but as TSY prices began to tick towards the topside, MBS offer prices slowly moved back toward the highs of the day.
Tomorrow is FOMC Statement day...speculatively we are still waiting for stocks to selloff and note that the long end of the yield curve isnt priced too expensively at the moment. Not a bad place to hide out while stocks head towards "the end of the line". Perhaps the market goes short heading into the auction and looks to cover in the auction...meaning we might see price weakness in the morning and a little recovery rally in the afternoon...btw this purely speculative thinking.
Plain and Simple: the inner thoughts cam was on!!!! FLOATING REMAINS SUPER RISKY....but I know many are rolling the dice as the possibility for upside rate sheet return remains high.
At 1:00pm the Treasury auctions $23 billion 10 yr notes. At 2:15 the FOMC statement is released.
Now its your turn to write...how do you think the FOMC statement will read tomorrow? Here is the June 24th statement....where do you think the FOMC adjusts and adds verbiage? (This will be fun for MG and I)
"Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months. Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.
The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted."
:-D
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