By the Numbers
A growing gap between pools and TBAs on the Street
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. This material does not constitute research.
The balance of pools sitting on dealer balance sheets has grown steadily since the mid-2022, according to the Federal Reserve. Short positions in TBA have also grown, but at a slower pace than pool balances. It is difficult to pin down the precise cause, but one possibility is that desks are doing more hedging with Treasuries or swaps instead of TBA. Another possibility, albeit one that seems less likely, is that low demand for conventional specified pools from banks has caused dealers to accumulate a larger balance of discount specified pools than is typically the case.
The balance of specified pools held on dealer balance sheets has been growing since April 2022 (Exhibit 1). Currently around $450 billion of pools sit on balance sheets, the solid red line, more than double the roughly $200 billion at the low point in 2022. This data is unavailable prior to 2022. Short positions in TBAs, the dotted red line, have also been growing over that period. But the net amount held bounced around in 2022 but has been growing steadily since the start of 2023, reaching nearly $70 billion recently compared to about $30 billion in early 2023.
Exhibit 1. Pool balances on dealer balance sheets have been growing since 2022.
Source: Federal Reserve, Santander US Capital Markets.
The Fed does not disclose data on position durations, which complicates understanding why this gap is growing. It is likely that most pools should be near the production coupon and are longer duration than TBA. If they are hedged duration-neutral with the same coupon TBA, then TBA balances should be larger than specified pools, the opposite of what the data shows. In other words, to hedge $1 in a relatively long-duration specified pool, the desk would need to go short more than $1 in the relatively shorter-duration TBA. Of course, a desk could hedge with TBA in a lower coupon with longer duration, requiring a lower hedge balance, but it would be unusual for a desk to take the coupon swap risk.
It seems likely that dealers are be filling in the spec-pool-to-TBA dollar duration gap by taking on basis risk and hedging with Treasuries, Treasury futures or swaps instead of TBAs. This would lower the balance of TBAs held relative to pools, so could be contributing to the gap. Dealers would pick up carry by hedging with Treasuries, Treasury futures or swaps. Yields on the fixed leg of SOFR swaps in the last few years and especially in 2024 have dropped well below Treasury yields—10-year swaps, for example, now yield 50 bp less than 10-year Treasury notes—so hedging with swaps has become much more attractive. Mortgage option-adjusted spreads are currently much wider against swaps than they are against Treasuries, so a dealer can earn more carry by hedging with swaps than Treasuries or TBA.
The economic incentive of hedging makes that a likely cause of this gap. But one other possibility, if dealers are fully hedging using only the same-coupon TBA, is that dealers have accumulated positions in discount specs that have shorter duration than discount TBA. This could be due to a lack of bank demand for conventional specified pools, and dealer balances are growing over time as they have difficulty finding buyers. This would explain why pool balances are growing despite a slowdown in mortgage origination and pool issuance. It suggests that dealer pool inventories are aging and, in a rising rate environment, could have accumulated an appreciable balance of low coupon specified pools. The sales of Silicon Valley Bank’s and Signature Bank’s assets in 2023 may have exacerbated this.
The ratio of TBA holdings to spec pool holdings has been declining over this time (Exhibit 2). Under the assumption that hedging is done with the same-coupon TBA, then this ratio should tell us something about the average hedge ratio—spec pool duration vs. TBA duration. But if hedging is also done with Treasuries, Treasury futures, or swaps, this inference does not work. The ratio is inverted—(TBA holding)/(spec holding) is like (spec OAD)/(TBA OAD). This ratio should probably be roughly constant over time if the specified pool holdings and TBA are always concentrated in the production coupon.
Exhibit 2. The ratio of TBA holdings to specified pool holdings.
Source: Federal Reserve, Santander US Capital Markets.
The falling ratio suggests that spec pool OADs have been falling relative to TBA OADs. That is consistent with the hypothesis that dealers are accumulating balances of discount specified pools. Looking back to 2022, it is plausible that the sharp decline from March through the end of June was caused by the initial jump to higher rates, then the hedge ratio increased as dealers normalized their balance sheets and hedges.
Conclusion
There is a strong incentive in today’s market for dealers to pick up carry by hedging their specified pool positions with Treasuries, Treasury futures, or swaps. Swap spreads are especially attractive right now. This has likely led to a widening gap between dealer’s specified pool positions and TBA positions over the last year. It is unlikely that dealers are underhedging their pools or hedging higher coupon specs with lower coupon TBA, two other possible explanations for the gap. A final possibility is that dealers have accumulated a large position in discount specified pools that have shorter duration than the same-coupon TBA. While consistent with the data, it seems more likely that dealer’s positions would remain near the production coupon.
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