It came as a big surprise for MBS players last week when Freddie Mac announced that it would be changing its prepayment accounting from a mid-month cycle to a calendar-month cycle.

Analysts say that though this would have positive long-term implications, short-term concerns are going to plague the market.

"These guys woke up today and all of a sudden their bonds were a few ticks less then they were yesterday," said a prepayment analyst.

Because of the change, the July 15, 2001 payment will incorporate all principal prepayments from May 16 to June 30, thus investors will be receiving 46 days of prepayments as opposed to the normal 30-31 days. However, the August 15, 2001 payment will reflect prepayments for the actual calendar month of July, and succeeding monthly payments will pass through prepayments for previous calendar months.

"The key impact on investors is that the prepayment paid out on July 15 will be about 50% larger than previously expected," said Art Frank, head of MBS research at Nomura Securities.

Interest-only (IO) holders, who in general are hurt by fast prepayments because they lose future income, will be among the hardest hit.

"For example, in June we are expecting Freddie Trust 209, backed by 2000-production Gold 7.5s, to prepay at about 6% Standard Monthly Mortality (52.4% CPR)," said Frank. "With this change we now expect it to prepay at about 9% SMM (52.4 CPR) for this month only. The additional negative carry on the Freddie Trust 209 IO for this one month is about 3/4 of a point."

Benefits of the arrangement

According to a UBS Warburg report, Freddie Mac has implemented this change to cut on the coupon they have to pay bondholders every time a prepayment occurs.

Experts say that in the long run, the change is good for the market.

"The accounting changes will improve the homogeneity of conventional passthrough product, and may very well increase Gold liquidity," said UBS.

In the meantime, the Bond Market Association is working to iron out the kinks.

Nomura's Frank said that the Association's Trading Practices Committee is now discussing whether Gold pools issued before September 1, 1995 (Freddie Mac is only revising its payment cycle for fixed-rate Gold PCs that came out since this date) should be allowed as good delivery in TBA trades.

Representatives from the Association declined to comment.

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