Bond Market Faces Collateral Squeeze

Terry Flanagan

The asset management industry faces a collateral squeeze with the implementation of the Federal Reserve’s margin requirements for all forward-settling agency mortgage-backed securities, typically transacted as To Be Announced trades (TBAs).

On Jan. 1, 2014, the Federal Reserve Bank of New York’s Treasury Market Practice Group’s (TMPG) margin recommendations for all forward-settling agency mortgage-backed securities (MBS) – typically transacted as TBAs – went into effect.

“With those recommendations, which should be treated more like requirements, the asset management industry faces a clear and present danger to their day-to-day operations, and if gone unnoticed, the rules could mean the New Year could start out with operational deficiencies, legal gridlock and a lack of collateral know-how on staff,” said Ted Leveroni, executive director of derivatives strategy and external relations at post-trade service provider Omgeo, in a blog posting.

“The sheer size of the mortgage-backed securities (MBS) market alone – approximately $270 billion in value traded daily, the majority of which are TBA trades – means that almost everyone will be impacted,” said Leveroni. “Up until now, no margin has been required for these types of trades, so firms will need to introduce a sophisticated collateral management process under an extremely tight and challenging timetable.”

The TBA market allows loan originators to take individual loans and turn them into a homogeneous product that can be traded. “When the Federal Reserve talks about buying mortgage-backed securities, it’s referring to the TBA market,” said Brent Nyitray, director of Capital Markets at iServe Residential Lending. “The Fed is the biggest buyer of TBA paper. TBAs are a completely “upstairs” market in that they don’t trade on an exchange and most trading is done ‘on the wire,’ or over the phone.”

TMPG’s recommendation states that collateralization should be performed under a formalized collateral agreement. “A big obstacle that asset managers will have to overcome with the TMPG guidelines is the recommendation that counterparties enter into a legal collateral agreement that defines the margining aspects of relationships, such as the frequency of collateral calls, the timing of these calls, and collateral eligibility,” Leveroni said. ”This will prove difficult, because up until now, no margin has typically been required for these types of trades.”

For asset managers that do not collateralize these transactions, compliance could be challenging when considering the specific capabilities of these firms and their current business relationships.

“The reality is that a significant proportion of the $5 trillion MBS agency market remains forward-settling and bilateral, and not collateralized,” said Leveroni. “Thus, the TMPG’s mandate will impact approximately $750 billion – $1.5 trillion in gross, unsettled, unmargined MBS trade exposure existing today.”

Asset managers will need a formalized collateral agreement with their counterparties. Negotiating terms of these agreements can take months, but it is an essential component of compliance with the recommendation, Leveroni said.

Some asset management firms are not legally permitted to physically deliver collateral. Those entities will need to formalize a tri-party control relationship which can take months.

“Many asset managers trading TBAs do not have operational or technical expertise in collateral operations, nor do they have the systems to properly support collateral processes,” said Leveroni. “These firms will need to find a suitable collateral management solution that can process and manage collateral.”

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