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Describe how pass-through agency MBS are traded.

FRM® Part I · Financial Markets and Products · Mortgages and Mortgage-Backed Securities · FRM1.FM.18.e

The idea

Agency pass-throughs mostly trade in the to-be-announced market, a forward market for generic securities. A TBA trade fixes the agency program, maturity, coupon, price, par amount and settlement date, but not the pools, which the seller announces about two business days before settlement. Because any pool meeting the good delivery rules can be delivered, TBA contracts are fungible, which makes the market liquid. Prices are quoted in 32nds, with a plus sign meaning an extra half of a 32nd. The buyer pays price × current face plus accrued interest. Current face = original face × pool factor. Accrued interest runs at the pass-through coupon on a 30/360 basis from the start of the month. Pools with special features trade as specified pools at a pay-up over TBA. The exam point is that the seller chooses what to deliver, so TBA prices reflect the cheapest-to-deliver pools.

Formulas

Invoice amount on a pass-through trade

invoice = price × original face × pool factor + accrued interest

price
the quoted price as a fraction of face, after converting 32nds
original face
the face amount traded at issue
pool factor
the share of original face still outstanding
accrued interest
pass-through coupon on current face, 30/360 from the start of the month

Price is applied to current face, not original face. A plus sign in the quote adds half a 32nd.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which set of terms is agreed on the trade date in a TBA trade of agency pass-throughs?

  1. The specific pool numbers, factors and weighted average coupons of the pools to be delivered.Why not: Pool details are exactly what a TBA leaves undetermined until notification.
  2. Only price and par amount, with agency, maturity and coupon chosen by the seller at delivery.Why not: Agency, maturity and coupon are part of the contract; the seller cannot change them.
  3. Agency, maturity, coupon and price, with the settlement date set when pools are announced.Why not: Settlement follows a standard monthly date fixed at the trade, not set at announcement.
  4. Agency program, maturity, coupon, price, par amount and settlement date. - correct

A TBA fixes the generic description, price, size and settlement date. Only the identity of the pools is left open until shortly before settlement.

A harder one

In a TBA trade, when does the seller tell the buyer which pools will be delivered?

  1. About two business days before settlement (the 48-hour rule). - correct
  2. On the trade date, when the price is agreed.Why not: The pools are unknown on the trade date; this would make the trade a specified pool trade.
  3. On the settlement date itself, at delivery.Why not: Pools are announced before settlement so that the invoice can be computed.
  4. About a month after settlement, when pool factors are published.Why not: Factors are needed at settlement to compute the invoice, so notification comes well before it.

TBA sellers notify buyers of the pools shortly before settlement, around 48 hours ahead. This allows the buyer to compute the invoice using the pools' factors.

The hardest tier

A buyer purchases USD 10 million original face of a 4.00% pass-through at a price of 98-16, settling on the 16th of the month. The pool factor is 0.85. Accrued interest runs for 15 days (30/360) at the pass-through coupon on current face. The total invoice amount is closest to:

  1. USD 9,866,667Why not: Applies the price and accrual to original face instead of current face.
  2. USD 8,386,667 - correct
  3. USD 8,400,833Why not: Accrues a full month of interest instead of 15 days.
  4. USD 8,372,500Why not: Gives the principal only and leaves out accrued interest.

Current face = 10,000,000 x 0.85 = 8,500,000. Principal = 8,500,000 x 0.985 = 8,372,500. Accrued = 8,500,000 x 0.04 x 15/360 = 14,167. Invoice = 8,386,667.

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