Next year is looking to be another interesting one for the MBS market and a contributor to this is the possibility of the implementation of a fails penalty.

Such a charge, "could ultimately be a seismic event in 2011, not as big as the buyouts of 2010, but important to rolls and specified pools," said JPMorgan Securities MBS analysts.

Until this uncertainty is resolved, "spreads will be under pressure" warned an MBS trader, and it looks like it might take some time before there is more clarity. JPMorgan analysts predicted that there is over a 50% probability of an announcement within the first half of next year, with the implementation coming three to six months thereafter.

Meanwhile, Credit Suisse analysts expect that the details of the penalty could be released as early as the last week of December if this follows the experience of the past two years involving key MBS announcements. Deutsche Bank Securities analysts said mortgage market participants who are participating in discussions regarding failed TBA trades expect a solution by the end of 1Q11 at the latest.

Fails recently hit more than $1 trillion - this has increased the odds of a fail charge. In a recent report, Barclays Capital analysts suggested that the huge amount of fails "could be the result of accumulated 'round-robin' fails in the system." An example of this is when A fails to B, which, in turn, causes B to fail to C - this could be counted as two fails. Additionally, analysts said that the dollar value of fails is calculated as a cumulative sum of total fails outstanding at the end of each business day, so "the actual number of fails could be much smaller if continual fails are re-counted each day."

Meanwhile, the spike in fails has not been accompanied by a jump in rolls, noted JPMorgan analysts. They think this could be a result of who the marginal buyer is. When the Federal Reserve was buying, dealers were probably reluctant to fail to them so they made sure bonds were delivered, which, in turn, pushed rolls higher. This time, however, the marginal buyers have been money managers and dealers and the dealers are probably more willing to fail to them, analysts said.

Both Barclays Capital and JPMorgan researchers noted that the sizeable fails will be a concern to regulators and raise the possibility of a fails charge. In fact, the Treasury Market Practices Group (TMPG) has been looking at ways to reduce fails.

Morgan Stanley analysts have stated that the group is working on a solution that is similar to the one implemented in Treasurys in 2009. However, MBS pose more of a challenge because of the nature of TBA trading and determining the appropriate prepayments in calculating carry, analysts explained.

Most market observers expect the issues to be resolved. Deutsche Head of Securitization and MBS Research Steve Abrahams said that the fee will probably be small. In recent trading, the firm noted pay-ups on specified pools had firmed slightly following rumors that a fails charge could be less severe than expected.


Will Penalty Reduce Fails?

While some believe a charge will be a net positive to the market, Credit Suisse analysts said it "is the wrong medicine" as it presumes that "delivery fails are intentional and shorts are simply hoarding available bonds that should be delivered into the tradable float." In this case, a charge will resolve fails if it motivates rolling investors to deliver, they said. However, this doesn't resolve the problem if the bulk of tradable float is held by non-rolling investors (like the Fed) and is not available for TBA trading.

In a report, the analysts highlighted a few potential adverse consequences of a fails charge that they think are possible. One disadvantage is that it encourages investors to get long an excessive amount of TBA in vulnerable coupons. They noted that, in this case, if there is a supply/demand imbalance, fails can persist and lead to huge profits for abusers of the system.

Another negative effect could be the reluctance by the Street to get short without being certain of access to bonds. This would reduce liquidity in non-production coupons, Credit Suisse analysts added. They also warned that there could be "more frequent, potentially persistent, and larger dislocations in valuations," noting the bar for relative value investors to short would be extremely high.

Given the concerns around the fails charge, Credit Suisse analysts expect that higher coupons should continue to outperform over the near term despite the rich valuations.

Using pay-ups as a guide to which coupons might be most affected, JPMorgan analysts said 5s and higher had a significant amount of their float at pay-ups between zero and eight ticks, while most 4% and 4.5% pools are trading at TBA levels.

As a result, a fails penalty on 4s and 4.5s would have less of an impact compared with higher coupons, they said. In preparing for the potential for a fails penalty, analysts recommended that investors "shift into pools off of low coupons (4.5s especially), which should be less subject to this event."

Barclays Capital analysts expect that if a fail penalty were implemented, rolls and the basis would likely trade well.

- Sally A. Runyan/Thomson Reuters

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