Montgomery Fixed Income
Second Quarter 2014
What are TBAs?
A TBA is a forward agreement to purchase or sell a basket of mortgage securities on a monthly settlement cycle with certain characteristics of the basket specified .
The price and amount are agreed upon at the time of the trade, but the exact pools are not known until two days before settlement, at which time, they are “announced.”
Thomas O’Connor, CFA
Managing Director, Senior Portfolio
Manager and Co-Head, Montgomery
Fixed Income
The TBA market has a long history, established in the 1970s alongside the creation of pass-through securities at Ginnie Mae. Today, most trading in the Agency Mortgage
Market occurs on a TBA basis with approximately $100 billion 1 of customerto-dealer transactions occurring on an average day. Given this transaction volume, intimate knowledge of TBA trading dynamics is essential for market participants.
Troy Ludgood
Managing Director, Senior Portfolio
Manager and Co-Head, Montgomery
Fixed Income
Why are TBAs useful?
TBAs facilitate trading efficiency by creating parameters under which mort gage pools can be considered fungible, thereby simplifying the analytical and risk management challenges faced by agency MBS market participants. The enhanced liquidity made possible via the TBA market benefits all participants in the mortgage market— from the mortgage borrower to the ultimate end investor. Originators can offer more competitive rates to borrowers by more efficiently hedging their risk in a liquid and transparent market. End investors benefit from lower cost transactions. Dealers gain from the large volumes that trade each day.
The key characteristics specified in a TBA forward agreement are typically:
 The Agency: Fannie Mae, Freddie Mac, or Ginnie Mae
 The amortization type: 30-years or 15-years
 The net coupon: these trade in 50 basis point increments (1/2 of 1%): for example 3.0%,
3.5%, 4.0%...
 The settlement date: there is one good delivery settlement date per month and there is normally a liquid TBA market for settlement up to three months into the future 2
• Maximum number of mortgage securities per basket
By way of example, one of the more liquid TBA contracts as of May 2014 was the
Fannie Mae 30-year 3.5% TBA. These contracts could be bought for May settlement, June settlement, or July settlement. One could also buy the same 3.0% coupon TBA in Freddie
Mac or Ginnie Mae guaranteed loans or with a 15-year amortization schedule.
For the above example, or any other TBA, the seller of the TBA must provide the buyer with specific pool information by 3 pm EST two days prior to settle ment.
The seller of the TBA has the option of delivering in any Agency mortgage pool that fits the original characteristics stipulated so long as they meet the Securities Industry and Financial Markets Association (SIFMA) good delivery guidelines. The current good delivery guidelines include a maximum variance of 0.01% per lot.

When a new borrower locks in a mortgage rate for a new loan, the originator will typically partially hedge the new mortgage’s rate by selling TBA contracts forward in the market. Selling the TBA forward effectively locks in the price at which the originator will be selling the mortgage, reducing the originator’s exposure to a subsequent sell-off in rates.
Diagram 1 illustrates the process a mortgage loan goes through from the initial mortgage borrower to the ultimate end investor.
Diagram 1: Life cycle of a mortgage loan securitized into an Agency MBS
Source: Wells Capital Management
Since the TBA market is used for pricing the majority of the Agency mortgage market, most Agency MBS are traded either as TBA, or at a price spread to TBA. This enables money managers such as ourselves to take advantage of the liquidity and transparency inherent in the
TBA market even for those parts of the market that are not TBA. Pools that have better characteristics than
TBA deliverable pools will trade at a “pay-up,” or premium to TBA. Even pools that are not TBA deliverable, such as jumbo pools and pools with loan-to-values greater than
105% are still priced relative to TBA.
TBAs are involved in most of the relative value trades that we make. Often TBAs are used as the hedge against other mortgage instruments we are buying or selling. It would be extremely rare for us to take physical delivery on a TBA contract. Usually, if we want a pool, we will buy a specified pool against the TBA so we know exactly what we are getting and avoid taking delivery of the worst bonds in the cohort.
 To manage duration changes and index extensions—buying and selling TBAs allows us to keep our mortgage exposure and duration where we want it, without incurring high transaction costs.
 To minimize transaction costs when trading other mortgage products—we will trade TBAs on swap versus specified pools or other mortgage products because negotiating only the price spread between the other product and TBA allows us to still tap into the TBA market’s liquidity for pricing purposes.
 To hedge a less liquid mortgage product—we normally buy or sell TBAs to hedge CMOs, hybrid ARMs, and less liquid pool stories such as 20-years.
 To gain additional carry versus owning pools in the situations when TBA dollar rolls are trading special, described below.
Understanding “cheapest-to-deliver”
For the largest most liquid parts of the TBA market, there are thousands of individual pools that can be delivered into a TBA sale to make good delivery. Since the seller has the option to deliver any pools that fit the original
Agency, coupon, and amortization schedule stipulations, it is i n the best interest of the seller to find the cheapest pools possible to deliver—these pools are known as
“cheapest-to-deliver.”
Differences in prepayment speeds among otherwise similar mortgage pools are an important factor in determining the cheapest-to-deliver pool. For TBAs trading at a premium dollar price (>$100), which tend to have higher yields, the seller will usually deliver pools that are prepaying faster than average, since higher yields are lost as borrowers prepay a greater percentage of the mortgage pool each month. The opposite is true for TBAs trading at a discount
(<$100), which tend to be lower yielding—the seller will deliver the slowest paying pools on TBA contracts, further extending the prepayment of the pool. The TBA market typically prices to this “worst-to-deliver” cohort of pools and market participants actively monitor and value what this cohort is.
In certain situations, the seller’s option to change what gets delivered into TBA can have value. Changing valuations and special situations such as when Fannie and Freddie changed their buyout policy regarding delinquent loans in the early part of 2010 can change what is deliverable into TBA. Subsequently, this option occasionally has real value for the seller.
Some examples of how our team uses TBAs:
 For relative value trading opportunities within the coupon stack or against other assets - we seek to take advantage of shorter-term pricing opportunities via the TBA market.
WELLS CAPITAL MANAGEMENT
TBA dollar rolls
TBA dollar rolls are used to move settlement from one month to the next month.
Rolling a long TBA
2

position involves simultaneously selling a front month TBA contract and purchasing a new TBA contract that settles the following month. A roll is simply the difference in dollar price between one delivery month and the next.
These rolls are typically quoted in 1/8th of 1/32nd of a point increments ($0.0039 per $100) for the most liquid
TBA contracts, and thus rolling TBAs from one settlement month to another has minimal costs.
A dollar roll’s fundamental value is determined by the difference in yield earned between taking delivery of a pool and current financing costs. A long TBA investor has the option each month of rolling a TBA contract forward to the next month or taking delivery of a pool. In a liquid coupon, the roll should be equal to the difference in carry associated with being long a mortgage pool between the two settlement dates and the carry associated with cash for the same time period. dollar priced pools from the market, leaving a tradable float that has better prepay characteristics than it otherwise would.
Speeds on the TBA deliverable pools for large premiums or discounts have a large effect on the valuation of the roll. In Graph 1 , the value of the Fannie Mae 30-year 4.5%
TBA roll is plotted against different CPR speeds. CPR is the
“Conditional Prepayment Rate” that is used to express the annualized rate at which the principal portion of a pool pays off prematurely. For example, a pool with a CPR of 20 indicates that 20% of the pool’s remaining principal balance is being paid off annually. At a 0 CPR and 107-00 dollar price the 4.5% roll is worth almost 12 ticks 3 a month while at speeds higher than 45 CPR the roll is negative. At faster speeds, the investor who owns the bond at 107% of par is getting more principal back at par every month.
Graph 1. The value of a TBA roll changes with prepayment speeds (CPR)
The inputs for a TBA dollar roll’s value is determined based on:
 Current financing costs which is a function of the cash yield
 The yield on the TBA deliverable pools which is dependent on dollar price, coupon, prepay speeds and seasoning
 Day count between delivery dates
 Value of the short’s option
 Technical factors such as a limited amount of float available
Rolling TBAs is often compared to entering into a repo relationship where the counterparty selling the roll is receiving financing and the counterparty buying the roll is providing financing. There are two main differences between getting financing via the repo market and getting it via the TBA dollar roll market. First, in the dollar roll market the same pools are not necessarily given back to the seller of the roll when the time period of the roll has expired. Second, in the dollar roll market the one providing financing (the buyer of the roll) is the one that keeps all interest and principal payments accrued while providing financing.
TBA rolls will often trade “special,” meaning that the roll
(or drop) is larger than would be implied by fundamentals alone. That is, the front month contract is trading at a higher dollar price relative to the back month contract than fundamentals would imply. When this happens, a long TBA position will earn more in carry because the back month
TBAs are purchased at a larger-than-normal discount each month. Recently many rolls have been trading special because of the large amount of mortgages the Federal Reserve has bought as part of its Quantitative Easing programs. The Fed has been buying TBA and taking delivery of pools when its
TBA settles. By buying and taking delivery of TBA the Fed has removed a sizable percentage of the fastest paying premium
WELLS CAPITAL MANAGEMENT
Implied value of the Fannie 30-year 3.5 May to June roll assuming funding of
0.00% and a front month dollar price of 107-00
Fails and fail charges
Similar to settlement fails in the Treasury market, fails in the
TBA market occur when the seller of TBA does not deliver the necessary pools on the agreed upon date. In a more traditional interest rate environment, fails do not regularly occur because the buyer of the security begins to earn accrued interest from the initially agreed upon trade date while the seller does not receive the money for the security until it actually settles, meaning that the seller is effectively providing interest free funding from the initial settlement date until the actual settlement date. In a low or zero interest rate environment, however, the cost to the seller of failing is significantly reduced because funding costs are already so low. Fails on TBA trades first became an issue in
2003 when the FOMC moved the target Fed funds rate to
1%. They became an even larger issue following the financial crisis when the target Fed funds rate fell to less than 0.25% and the Fed was buying most of the gross issuance. Elevated fail levels create market and systematic inefficiencies as well as increase counterparty credit risk. To help counteract
3

the widespread fails the Treasury Market Practices Group
(TPMG) implemented a fails charge for the mortgage market that became effective February 2012. The 200 basis point fails charge has, as expected, significantly reduced the overall level of fails.
Graph 2. Mortgage fails through time
The end investor benefits by reducing counterparty credit risk and disposing of the need to take pools in from Counterparty A at settlement to turn around immediately and deliver the pools back out to Counterparty B. The cash flows associated with the TBA trades still occur on the regular settlement date with any difference in TBA trade prices being monetized at settlement with corresponding cash flows.
Source: New York Federal Reserve
Round robins
Also helping the amount of fails in the system has been the more widespread usage of Round Robin transactions to net counterparty exposure. Round Robins eliminate some of the counterparty risk that exists absent a clearinghouse. In a
Round Robin trade, an end investor steps out of the middle of a trade in which he bought TBA from one dealer and sold to another and has the two dealers face each other.
As an example, if an investor bought a specific TBA from
Counterparty A and a week later sold to Counterparty B leaving his net exposure flat, the Round Robin trade would have the investor selling the TBA back to Counterparty A and buying it from Counterparty B with Counterparty A and
B simultaneously entering another trade at the same price in which Counterparty A would be selling to Counterparty B.
Margining
Margining of TBAs became more widespread in 2014. The
TMPG has pushed to get margining implemented to specifi cally counteract the counterparty credit risk that occurs in a TBA trade between trade date and settlement date. This margining requires market participants to exchange twoway variation market on a regular basis in contrast to the prior practice of cash flows only changing hands at settlement. Many market participants are still working through the several operational and legal issues involved with setting up a margining process.
Going forward
As the mortgage market evolves and the future course of the GSEs becomes more certain, the TBA market will evolve with it. The current regulator of Fannie and Freddie, the
Federal Housing Finance Agency, has stated that preserving mortgage market liquidity is a goal of any GSE reform. Given that the TBA market is where liquidity resides in the Agency mortgage market and is a vital instrument for any market participant, it is likely to continue to be a large part of the market for the next several decades just as it has been for the last few.
1 Estimate from TPMG using data from FINRA.
2 Each type of TBA only has one good delivery settlement date per month but there are different settlement dates within a month for different classes of
TBA. Fannie and Freddie 30-years share the same good delivery settlement date, 15-years have a good delivery settlement date that comes after Fannie and Freddie 30-years and then Ginnie Mae 30-years settle still later in the month.
3 A tick is 1/32nd of a point or $0.03125 per $100 face amount.
Note: CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.
Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The Montgomery Fixed Income team portfolio managers have written this commentary for informational purposes only, and it is not intended as an offer to sell or a solicitation of an offer to buy any security. The views expressed on the financial markets and security valuations are based on the judgment and experience of the Montgomery Fixed Income team. Past performance is not a guarantee of future returns. It should not be assumed that the portfolio holdings discussed or investments made in the future will be profitable or will equal the performance of those discussed in this commentary. A complete list of holdings and portfolio commentaries are available for the past year upon request.
WELLS CAPITAL MANAGEMENT® is a registered service mark of Wells Capital Management, Inc.
4