Bloomberg News

Industry Group Cuts MBS Fail Charges, Pimco Says Still High

June 28, 2011

(Updates with Pimco in first paragraph, background starting in third.)

June 28 (Bloomberg) -- An industry group that advises on transactions in U.S. securities revised a proposal that would penalize dealers and investors that fail to complete mortgage- bond trades at agreed-upon times. Pacific Investment Management Co. said the lower fees may still damage the market.

The Treasury Market Practices Group, formed in 2007 with the help of the Federal Reserve Bank of New York to offer advice on debt markets, said the charge for trade failures should be 2 percent minus the federal funds target rate, which is now as low as zero. The group suggested as much as 3 percent in April.

The U.S. central bank’s decision to hold benchmark interest rates at record lows has encouraged failures by reducing the cost of uncompleted trades, while its purchase of $1.25 trillion of mortgage bonds through March 2010 has made it more difficult to find bonds to settle contracts in a timely manner.

“This is long overdue given the distortions these fails have been creating,” said Tae Park, a money manager in New York who oversees mortgage-bond investments at Societe Generale SA, France’s second-largest bank.

Uncompleted trades in the $5 trillion market for agency mortgage securities remain elevated after rising to a record of almost $2.4 trillion during a week in November, according to Fed data. Agency mortgage bonds, the type affected by the proposed market rules, are guaranteed by government-supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae.

‘Hoped for Lower’

TMPG recommended that the charges for the failed mortgage- bond trades apply starting Feb. 1, the group said in a statement posted today on the New York Fed’s website. The proposed fees would remain as much as 3 percent, its initial suggestion, for uncompleted trades of corporate debt from Fannie Mae, Freddie Mac and the government-chartered Federal Home Loan Bank system. These charges may also begin in February.

While the 2 percent maximum for mortgage-bond failure fees would be better than 3 percent, “we had hoped for lower still,” Scott Simon, Newport Beach, California-based Pimco’s mortgage-bond head, said in an e-mail.

“We are afraid that the 2 percent charge is still high enough that it will entice people to attempt short squeezes and reduce liquidity,” said Simon, whose firm runs the world’s largest bond fund. A short squeeze refers to hoarding of bonds that may be needed to be bought to complete trades.

Tom Wipf, the TMPG’s chairman, said that the charges will “effectively reduce fails and support liquidity in the market” in the statement released today.

Increases Possible

“If fail levels do not decline satisfactorily within the first few months after the charge takes effect, the TMPG will consider raising the charge level,” said Wipf, who’s also a Morgan Stanley executive.

Failures to receive or deliver agency mortgage securities totaled $861.2 billion in the week ended June 15 among primary dealers, compared with an average of about $330 billion weekly over the past 10 years, according to Fed data. The tallies are inflated both by incomplete trades that continue over multiple days and by strings of failures triggered by a single party that doesn’t settle a contract.

An electronic method to reduce chains of failures that was introduced last year by Tradeweb LLC, the bond- and derivatives- trading network partly owned by Wall Street’s largest banks, may have helped reduce uncompleted trades from their peaks.

The TMPG’s effort to create mortgage-bond fail charges follows the introduction of a similar practice for U.S. government bonds that the organization backed in 2009.

Cost of Failures

Cutting the number of uncompleted mortgage-bond trades is necessary for individual companies because “fails can increase operational costs and counterparty credit risk, absorb scarce capital through regulatory charges, and damage customer relations,” the TMPG said in a paper released in April. Also the problem can drive investors from the market, hurting stability and liquidity, the group said.

The Fed’s decision to hold its target for the federal funds rate in a range of 0 percent to 0.25 percent since 2008 has helped encourage fails because it lowers the cost of not receiving cash in exchange for the promised securities. In a higher-rate environment, dealers would lose more because that cash could be invested at higher yields.

Lower rates boost the incentives for investors or dealers that want to “short,” or bet against, mortgage-bond prices to delay delivering bonds into sales contracts, according to the group’s paper.

Most transactions in the mortgage-bond market are conducted through so-called To Be Announced trading, which also adds incentives to fail on those contracts. TBA contracts can be filled through delivery of securities with a range of characteristics, rather than specific bonds.

That gives dealers and investors a motive to wait until they acquire “less valuable” securities before completing trades, according to the industry group’s paper.

--Editors: Richard Bedard, Pierre Paulden

To contact the reporters on this story: Jody Shenn in New York at jshenn@bloomberg.net

To contact the editors responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net;


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