New MBS Margin Requirements Create Clear and Present Danger
By Ted Leveroni, Omgeo
Originally published on TABB Forum
Margin recommendations for all forward-settling agency mortgage-backed securities that go into effect on Jan. 1 could mean a New Year full of operational deficiencies, legal gridlock and a lack of collateral know-how for the asset management industry.
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 To Be Announced trades (TBAs) – will go 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.
TMPG’s requirements are accompanied by an aggressive implementation timeline. Market participants are expected to have a complete margining solution by the end of this month, and the MBS market – which is approximately $270 billion in value traded daily, the majority of which are TBA trades – is massive, meaning asset managers will feel the impact.
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. This will prove difficult, because up until now, no margin has typically been required for these types of trades. This means that the vast majority of firms will need to introduce a brand-new, robust, flexible and sophisticated collateral management process. The reality is that a significant proportion of the $5 trillion MBS agency market remains forward-settling and bilateral, and not collateralized. Thus, the TMPG’s mandate will impact approximately $750 billion – $1.5 trillion in gross, unsettled, unmargined MBS trade exposure existing today.
Role of TBA Market
The TBA market is essential for the proper functioning of the retail mortgage market, and it can be argued that if a major counterparty default occurred in this market, it could have a disproportional impact on the general public. This is no hollow threat given the current lack of collateralization on bilateral TBAs. During the settlement process of a TBA, parties are open to counterparty default risk for the period between execution and settlement. According to FINRA estimates, the average time between execution and settlement today is about 25 days, but can last as long as long as three months.
The lack of collateralized TBA transactions introduces compliance challenges when considering the specific capabilities of these firms and their current business relationships. One primary issue is legal set-up. TMPG’s recommendation states that collateralization should be performed under a formalized collateral agreement. The industry standard for such a collateral agreement between parties trading in forward-settling mortgage-backed securities is the Master Securities Forward Transaction Agreement (MSFTA). The Securities Industry and Financial Markets Association (SIFMA) recently revised its standard recommended template for the MSFTA, which can be used as a starting point for negotiations between counterparties. However, it is only a starting point, and the detailed terms must be negotiated and agreed on between the trading parties.
The next issue is relationship formalization. Some buy-side firms are able to deliver collateral directly to their counterparties; however, others are not legally permitted to physically deliver collateral. Entities without legal permission will need to formalize a tri-party control relationship among their organizations, their custodians, and their counterparties in order to comply.
All of these steps are compounded by requisite operational and technical preparation. For those firms trading TBAs without operational or technical expertise in collateral operations, building an in-house solution or leveraging existing licensed technology is not an option. They will need to find a suitable collateral management solution that can process and manage collateral under an MSFTA. For firms that already have collateral management departments that leverage sophisticated and flexible collateral management technology across other asset classes, it will be important that they review their processes and technology to ensure that they can handle all forward-settling MBS margining.
Market risk reduction is a goal the financial industry should work toward. TMPG’s recommendations will promote safety in the TBA market, if asset managers take the correct precautions to safeguard their transactions. In order to ensure the TBA market will function efficiently once the new regulations are in place, the asset management industry must take steps today to ensure they comply in a timely manner with these new regulations to help reduce the potential for risk.