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Here’s A Breakdown Of How Mortgage Allocation Works

When mortgage-related information is given to a mortgage-backed security buyer by a mortgage-backed security seller, it is called mortgage allocation. When the mortgages that make up a mortgage-backed security (MBS) are not established at the time of the trade, the MBS is traded in secondary markets as TBA (to-be-announced) trades.

How this works is that the seller of an MBS (mortgage-backed security) needs to give the MBS buyer an estimation of the mortgage that the buyer will receive in the future when the trade is made.

Here’s A Breakdown Of How Mortgage Allocation Works
The sellers of a to-be-announced trade need to provide information about the securities that the buyers will obtain in the trade 48 hours prior to the established settlement date.

For example, X is a seller and Y is a buyer, and X sells Y an MBS today. Now, at the time of the sale, neither of the two knows which mortgages will make up the MBS. If the settlement date is set for 3 days from today, X will be required to tell Y by tomorrow (48 hours prior) about the securities (with an allowed variance of only 0.01%) that Y can expect to receive at the time of settlement.

A brief history of mortgage allocations
With the development of the ‘to-be-announced’ trade market, mortgage allocations were done either manually or with existing limited software. Nowadays, it is done only with the help of advanced software that saves traders from the stress associated with the allocation scheme. Without the required software in the past, the 48-hour period before the settlement date was a stressful time for the TBA sellers and other marketers.

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The workings of a mortgage allocation are such that each trade is broken down into lots of $1 million, with an allowed variance of 0.01%, and one allocation can contain a maximum of 3 such pools. Initially, when it was started in the 1980’s, the variance rate was much higher than 0.01%, which earned sellers more profits than they do today. Let’s assume the TBA (to-be-announced) trade as X and the actual trade as Y. If the market price of X turns out to be higher than that of Y, by putting in the minimum amount of variance into the trade and then selling the difference, traders could earn profits.

Now, if the trade price was higher than the current market price, the trader would purchase the difference between X and Y at a lower market price instead of selling. While all of this was quite complex in the past, the use of advanced software has made this a fairly easy process.

Usefulness of mortgage allocations
Since the securities in TBA trades are unknown, the actual value of MBS is estimated at the time of the trade. Therefore, the total value of the mortgages that make up the allocations is not allowed to deviate by more than 0.01% from the price of the trade. This is to provide a guarantee to the buyers when the trade is settled.

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