Fed buying should keep rolls special for some time

admin | June 19, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Fed has bought MBS at a record pace in order to stabilize markets in response to the COVID-19 pandemic, buying $751 billion from mid-March through June 18. Going forward they have committed to adding $40 billion a month with no stated end date. Dollar rolls have typically traded special when the Fed has been an active buyer, and the current market appears to be following the same pattern. The 2.5% and 3.0% rolls are currently offering financing well below one-month LIBOR. This is likely to persist while the Fed remains a buyer, which could be for a long time. This will put pressure on pay-ups for specified pools, and possibly make it uneconomical to create pools that would typically command a low pay-up.

The influence of the Fed on dollar rolls during QE1, QE2, and QE3

The Fed also bought a significant amount of agency MBS in response to the 2008 financial crisis. The first round, known as QE1, was announced in November 2008 and MBS purchases began in January 2009. The Fed continued buying until August 2010, when the portfolio peaked in size at a little over $1.1 trillion. The FNCL 3.5% dollar roll traded special throughout almost this entire period (Exhibit 1), usually offering at least 50 bp lower implied financing rates than 1-month LIBOR.

Exhibit 1: Roll financing is typically below 1-month LIBOR when the Fed is buying

Note: The exhibit shows the financing advantage of the FNCL 3.0% and 3.5% dollar rolls since the beginning of 2009. The financing advantage is the difference between 1-month LIBOR and the implied financing rate of the dollar roll; a number greater than zero indicates that the roll is trading special—offering financing rates better than LIBOR. Source: Yield Book, Amherst Pierpont Securities

Following the end of QE1, the Fed allowed their MBS holdings to shrink, reinvesting MBS paydowns in Treasuries. During this time, the financing advantage of dollars rolls dwindled. However, in September 2011 the Fed announced QE2, which redirected MBS paydowns back into MBS and authorized a large Treasury purchase program. Dollar roll financing became increasingly special over the course of QE2.

In September 2012 the Fed announced QE3, which included an open-ended commitment to purchase $40 billion MBS each month in addition to reinvesting MBS paydowns. Roll financing remained strong into 2013, but in the second half of the year began to weaken as it became clear the Fed would eventually slow their MBS purchases. Mortgage rates increased over 100 bp in May and June 2013 due to fears the Fed would begin tapering their MBS purchases. Slower projected prepayment speeds pushed dollar roll financing rates higher. By late 2014 the Fed was back to only reinvesting MBS paydowns and the financing advantage disappeared for 3.5%s in 2016.

Finally, in late 2017 the Fed permitted the MBS portfolio to shrink as MBS pools paid down. During this time, which lasted until the pandemic, roll financing was often at rates slightly higher than LIBOR. During 2019 overnight repo rates for MBS were generally slightly higher than one-month LIBOR, and monthly MBS funding rates were even higher than overnight rates. This was reflected in the dollar roll as well.

Funding markets experienced significant stress in late 2019, exemplified by a spike in overnight funding rates on September 17. From September 16 the SOFR index jumped to 5.25% from 2.43% and the DTCC’s GCF Repo Index jumped to 6.70% from 3.11%. The Fed had to intervene to stabilize markets. Dollar roll financing was consequently very expensive during this period as well, especially for 3.5%s. Financing rates for that coupon were often 100 basis points higher than one-month LIBOR for the last four months of 2019.

The pandemic and QE4

The 3.0% roll is currently trading special and has been throughout much of the QE4 era. The 2.5% roll, which is not pictured since there is not much data throughout many of the earlier periods, is also trading special. The Fed has bought more MBS in these two coupons than any other; almost 71% of their 30-year conventional MBS purchases have been in 2.5%s and 3.0%s. Heavy Fed buying increases demand for those TBA contracts in the front month, which improves the financing rates.

As of now there is no end date for the Fed’s QE4 MBS purchase program. In the past the Fed was generally very cautious about first tapering MBS purchases and even more cautious about permitting the portfolio to shrink. If that proves true with QE4, then the Fed could remain a major buyer of MBS well after the COVID-19 pandemic has abated. These rolls could be trading special for a very long time.

Other factors influence roll financing, too

The pace of Fed MBS purchases is not the only factor that affects roll financing. Bank demand is a major factor since banks generally do not roll their positions. Demand for CMOs has a similar effect since pools locked into CMOs cannot be rolled. The net supply of MBS can also vary widely and was even negative for sustained periods following the financial crisis. However, the Fed is able to buy MBS on an enormous scale and as the specialness of the roll is consistent with the Fed’s involvement in the MBS market.

Special roll financing lowers specified pool pay-ups

Pay-ups for specified pools generally fall when roll financing is special. This is because the carry in the TBA contract improves significantly. In some cases, depending on the degree of specialness and its expected length, carry in TBA can be much better than holding and financing a specified pool. This causes pay-ups to drop, and investors and originators often find it better to deliver low pay-up collateral into the TBA bid.