TBA, dollar roll volumes return to pre-pandemic marks

Brian Landy, CFA | April 1, 2022

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.

MBS trading volume has fallen below the average level from 2019, a consequence of slowing refinance activity and lower MBS purchases by the Fed. And volume could fall further as it starts to reflect the full increase in mortgage rates. But strong home sales should keep net MBS supply high and offset some of the drop. Dollar roll activity also could receive a boost when the Fed begins to shrink its MBS portfolio.

TBA trading has fallen below the 2019 average

TBA trading volume has fallen since early 2021, a steady decline disrupted only by a small jump in activity in the fall. Refinance activity slowed over the course of the year as originators were left with a smaller group of borrowers able and willing to refinance. Mortgage originators routinely hedge originations with TBA contracts and roll those contracts to manage pipeline interest rate risk, so heavy origination can contribute to increased TBA and roll trading. Gross and net issuance reached record highs for Fannie Mae and Freddie Mac in 2021. Gross issuance should fall sharply in 2022 as refinancing volume vanishes. But a strong housing market should keep net supply robust.

Exhibit 1. TBA trading volume is slightly below 2019 levels

The dark blue line is weekly trading volume, the light blue is fit using LOESS to smooth seasonal variation.
Source: Federal Reserve, Amherst Pierpont Securities

The Fed’s MBS purchasing activity for most of 2021 followed a steady pace of adding $40 billion a month, so it is unlikely that contributed to falling volumes throughout the year. However, the Fed started to reduce net buying late in the year and ended net buying in March. This probably contributed to the drop in volume at the end of the year, along with a typical seasonal slowdown. The smoothed line does make it appear that volume picked up slightly over the last two months but most likely reflects the bounce back from the seasonal low at the end of each year.

Dollar roll usage has also returned to pre-pandemic levels

Dollar roll usage has also returned to 2019 levels, although that happened earlier in 2021 than it did for TBA trading. Rolls were special throughout much of the pandemic, which has typically been true when the Fed has been a heavy buyer of MBS. Many money managers and other investors chose to roll TBA instead of investing in specified pools to take advantage of the special carry. Roll specialness has generally weakened this year, although the shift to higher interest rates has caused rolls in 3.5%s and higher to spike. Market activity tracked the production coupon higher, but origination volume has not yet caught up with the move.

Exhibit 2. Dollar roll trading volume is also close to 2019 levels

The dark blue line is weekly trading volume, the light blue is fit using LOESS to smooth seasonal variation.
Source: Federal Reserve, Amherst Pierpont Securities

The last time the Fed decided to shrink its MBS portfolio was in 2017 and 2018, which may have contributed to an increase in dollar roll usage in the second half of 2018 into 2019. The Fed started reducing its MBS portfolio balance in October 2017. Prior to that date, the Fed reinvested 100% of MBS paydowns into new MBS. Beginning in October the Fed permitted up to $4 billion of paydowns per month to run off their portfolio. Every quarter in 2018 the Fed increased the amount of MBS that it would permit to run off by an additional $4 billion per month, until reaching a maximum of $20 billion per month runoff in October 2018. Increases in the runoff cap decrease the Fed’s MBS purchases. In mid-2018 the Fed was purchasing less than $10 billion of MBS per month, and the amount fell below $1.0 billion per month starting in October 2018.

The pools the Fed would have bought were instead purchased by private investors. The Fed did not report any dollar roll transactions during that time, but it is likely that the private investors that replace the Fed’s MBS purchases would dollar roll. That would account for some of the increase in activity.

Dollar roll usage could increase similarly this year since the Fed is expected to allow its MBS portfolio to runoff. This process could start as soon as the May FOMC meeting. The Fed is likely to allow runoff of at least $30 billion a month since the MBS portfolio is larger than in 2017. And with a pressing need to combat inflation the Fed may need to ramp up to that cap quickly.