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Secondary market.

On March 2, the Public Securities Association's (PSA) Mortgage Securities Executive Committee announced that it was modifying its good-delivery guidelines for all delay-delivery or to-be-announced (TBA) trades for mortgage pass-through securities. Specifically, PSA ruled that, effective with trades done on or after March 16, (and setting on or after July 1, 1992), the allowable variance will be reduced from +/- 2.499999 percent to +/- 2 percent of the dollar amount of the transaction involved. PSA sent clear signals that the .5 percent reduction should be viewed as the first step to achieving its ultimate goal - lowering the allowable variance to +/- 1 percent or less. Prior to the announced change, PSA had proposed the following six alternative proposals to MBA: * No change; * Reduce variance to between 0.5 percent and 1.5 percent; * Same as bullet two except that when sellers, who are also the originators, deliver a whole pool trade of $2 million or less, the variance would remain at 2.5 percent; * Variance is reduced to 1 percent except for the last $1 million per trade; * Allowable variance is based on a sliding scale based on the size of trade (e.g., 2.5 percent for trades of $1 million) down to 1 percent for trades of $5 million or more; * Retain current variance and reduce net proceeds by the change in price between trade date and settlement so as to eliminate any economic incentive to deliver more or less than the trade.

MBA opposes all but bullet one. PSA has maintained that investors are demanding a lower variance and that PSA is acting on their behalf and not in the economic interest of the dealer community. MBA is not convinced that investor demand for a lower variance is as widespread as we have been led to believe. Even if it were true that investors are demanding a lower variance, MBA would be opposed to it because of the operational difficulties and added secondary market cost it would cause.

PSA is under the impression that mortgage companies delivering securities to the Street are obtaining hugh economic windfalls when they maximize the use of the variance. It should be no surprise that an economically rational mortgage company would seek to maximize the use of variance especially since the mortgage company incurs a cost for the option by accepting a lower security than the company would receive if the security were sold with zero variance. Moreover, economic windfalls over a period of time are unlikely when all the costs of secondary operations are taken into consideration. The secondary market department of a mortgage company is basically a break-even operation. The economic value of maximizing variance only offsets some of the costs of hedging the pipeline and the cost of the variance option.

There are other limits on mortgage companies receiving windfall economic gains. For Ginnie Mae's in particular, the fact that the pools have to be formed 20 days prior to settlement makes maximization of the variance an interest rate guessing game. Moreover, the possibility of windfalls only exist under rare interest rate scenarios when MBS price changes move dramatically over a short period of time. But even then there is likely to be a concomitant increase in the mortgage company's hedging costs to diminish the gain from variance maximization.

Finally, we believe that dealers/investors are capable of efficiently pricing the variance option. The price an MBS seller pays for the variance option is the difference between the price received for the security and the additional value the seller would have received if the trade had been done with an investor who was willing to pay up for a lower variance. This is the price a mortgage company is willing to pay to have the operational flexibility to deliver + 2.5 percent of the trade. Wall Street writes and prices options everyday. If investors want a lower variance, they can specify that and pay up for the security. One mortgage banker explained it to me this way: If a dealer, bids 100.00 on a $1 million MBS with + 2.499 percent variance, it has effectively agreed to buy a $1 million MBS with a zero tolerance and at the same time written an "at-the-money" put and an "at-the-money" call for $24,999 for each option. The put and call have value related to the length of time until settlement. If settlement is, say, 60 days out, the value would be approximately 1 point or $499.98. Based on the original commitment for a $1 million MBS, this equates to 4.999 basis points or slightly more than 1.5/32nds. This analysis simply indicates that the value of the variance option can be calculated and incorporated into the price offered for the security. Wall Street uses sophisticated analytics to price the variance option more precisely than illustrated in the simplistic example. PSA has indicated that a tighter variance should lead to higher prices for securities delivered. This remains to be seen.

MBA is very concerned about the adverse impact associated with PSA's drive to move the variance lower and lower. Tighter variances are likely to cause serious operational problems as average loan amounts rise. Putting together small trades with a tight variance in volatile markets will become increasingly difficult, resulting in more delivery failures or more pair-off costs. Tighter variances will also impact on consumer choice because lenders will be more inclined to create loans that are easily substitutable should loans fall out of the pipeline minimizing the prospect of a fail. In addition, smaller companies may also find that their limited loan substitution capacity may force them to deal with intermediaries rather than dealing directly with dealers.

Finally, MBA is not satisfied with the process through which good delivery rules are established. To PSA's credit, this time they made an effort to consult with us. MBA, Fannie Mae and Freddie Mac were allowed to express their views but in the final analysis, PSA has the ability to dictate what constitutes "good delivery" for trades. MBA maintains that decisions on good delivery should be made jointly by the participants affected by these guidelines.
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Title Annotation:Public Securities Association's modified good-delivery guidelines
Author:Taliefero, Michael S.
Publication:Mortgage Banking
Date:Apr 1, 1992
Previous Article:Technology.
Next Article:Boardroom view.

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