Understanding the Process of Mortgage Allocation in Securities Trading
This article explains the process of mortgage allocation in mortgage-backed securities trading, highlighting its historical development, current practices, and importance. It emphasizes the role of advanced software in simplifying allocations, the significance of tight variance limits for accuracy, and the need for transparency in TBAs, providing valuable knowledge for investors and industry professionals.
Overview of Mortgage Allocation in Securities
Mortgage allocation refers to the process where details about the underlying mortgages are provided to the buyer of a mortgage-backed security (MBS) by the seller. When the specific mortgages constituting an MBS are not finalized at the time of transaction, the security is traded on the secondary market as TBA (to-be-announced).
In this process, the MBS seller must estimate and communicate to the buyer the characteristics of the future mortgage pool at the time of trade. Sellers are required to deliver this information at least 48 hours before the agreed settlement date.
For instance, if Seller X offers an MBS to Buyer Y today, neither party will know the exact composition of the underlying mortgages at the moment of sale. If the settlement is scheduled three days later, Seller X must inform Buyer Y about the expected mortgage pool by tomorrow, with a minimal variance allowed of 0.01%.
A Brief History of Mortgage Allocation
Historically, mortgage allocations were handled manually or with basic software, which made the process challenging. Today, advanced software automates these tasks, alleviating stress for traders and ensuring precise estimations within the allowable variance.Additional Insights on Mortgage Allocation
Typically, each mortgage trade is divided into $1 million segments, with a maximum of three pools per allocation, and only a 0.01% variance is permitted. During the 1980s, a higher variance rate benefited sellers by increasing profits. If the market value of the initial trade exceeds the actual executed trade, traders could profit by exploiting the small variance margin.
Conversely, if the trade price was lower, traders could buy at a cheaper market rate to cover the difference. Modern software has simplified these calculations, making the process more efficient and less risky.
Importance of Mortgage Allocations
Since TBAs involve unknown securities, the estimated value of the MBS at the time of the trade must stay within a tight 0.01% deviation from the quoted price, ensuring transparency and reliability upon settlement.
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