Fails to deliver — to the moon!
That’s trade settlement failures in mortgage-backed securities (MBS) — the most liquid US bond market after US Treasuries — and they’ve spiked this summer. The fails occur when the MBS seller fails to deliver on an agreed upon settlement date. This is a problem for both buyers and sellers since it means they could have to go and buy them out in the open market for what could be a higher or lower price.
The recent surge in fails can be attributed to a few things.
First and foremost there’s the Fed Funds rate — currently (still) hovering at record lows. That means failing to deliver has become very cheap, and sometimes even profitable. If a seller fails to deliver then he misses out on the cash from his buyer, which means he can’t invest at the risk-free rate. But with that rate at an all-time low, he’s not really missing out on much.
Moody’s analyst Alexander Yavorsky wrote back in February that:
Currently, “fails to deliver” exceed “fails to receive” by about $100 billion, a good measure of “intentional” fails. [They now amount to about $44bn]
This, incidentally, is something that happened the last time Fed funds rates were extremely low. Back in the summer of 2003 “low overnight rates” were also being blamed for an increase in fails, along with higher prepayments (a risk for MBS) and a general supply-demand imbalance in the market.
Which brings us to the next point.
The Fed has cornered much of the market for agency MBS with the MBS-buying portion of its quantitative easing. That’s left little to settle open trades. Meanwhile, current market worries about prepayments means that dealers are still doing plenty of sifting between MBS pools to find the cheapest to deliver bonds based on expected prepayment rates. They’re looking for pools that will pay slower than average, but that means spending extra time on sorting, and risking more failures.
Who cares about more MBS failures?
The dealers do, for one. A higher number of fails means they could well have to hold on to more regulatory capital. There’s also been some suggestion that the increased uncertainty caused by fails could drive away some MBS investors. On a more immediate note MBS fails risk knock-on effects.
As in settlements of UST trades, these are called ‘daisy chains’ or ‘round robins’ of failures. And they happen when one failure to deliver causes another fail deliver, and so on. Such failures, as Moody’s notes, can have a ballooning effect on a dealer’s balance sheet — potentially causing a dealer default.
In a rather ironic way then, the Fed has risked some systemic stability in its efforts to prop up US housing by buying-up the market for agency MBS. The same doesn’t yet seem to apply for the US Treasury market — where the Fed already owns more than a third of many outstanding issues — but perhaps it will.
The future of the MBS market
Most in the industry still expect the MBS market’s supply-demand imbalance to ease in the future — and you can see the proportion of fails has already started to drop in that chart. The Fed decided last week to reinvest the proceeds of maturing MBS in its portfolio into US Treasuries — something which could boost MBS supply in the long-run considering the Fed is no longer buying MBS.
However, there are those who seem to be betting MBS fails might continue.
We note for instance, a patent application, published this summer, for a “system and method for processing failed trades” in MBS. The inventors cite increasing “industry-wide delays and failures in transaction settlements” as one of the reasons for their invention, along with rising demand for MBS.
As for immediate data points — the Fed will be publishing its weekly fails info for MBS and US Treasuries later this week, which should give some insight into whether tightness continues in the (MBS) market, or whether there’s been a run on high-quality collateral in general (USTs).
Can’t wait.
Related links:
Agency MBS trends – Credit Suisse
Pondering the MBS paydown stimulus - FT Alphaville
Fed finds no good deed goes unpunished as mortgage trades fail - Bloomberg