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Why is there prepayment risk for a TBA?

December 13th, 2019, 8:54 pm

I've read that a TBA is a forward on a mortgage pool.  The pool is not specified at the time the investors pays for the TBA (which is delivered on a "worst to deliver" basis).  If the trade was for $10M, then the investor will get $10M of MBS notional.

I see the interest rate risk (of course).   But why is there a prepayment risk?  If there are no actual loans in a TBA, why is there prepayment?
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Re: Why is there prepayment risk for a TBA?

December 15th, 2019, 9:46 pm

Not really my area, but since our fixed income gurus haven't answered, I'll take a shot.

If interest rates drop a lot before delivery, then the pool you end up with will likely pre-pay faster than it would have otherwise. After all, it must take some time to package the mortgages, so presumably many of the ones you get will have been underwritten at rates higher than delivery-day rates. So, the effective maturity of your pool will be shorter than it would have been otherwise. (And the opposite effect, of course, if rates rise). This risk is distinct from the interest rate risk for a vanilla bond without (or with less) embedded optionality.
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Re: Why is there prepayment risk for a TBA?

January 4th, 2021, 1:37 pm

The TBA is just a futures contract on loans with prepayment risk. Because worst to deliver is the assumed deliverable, assume the TBA is that loan.
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Re: Why is there prepayment risk for a TBA?

January 4th, 2021, 10:35 pm

Right(ish). Strictly speaking, the TBA is a forward contract, but with an embedded delivery option that’s similar to a bond futures contract. Since the contract actually specifies the MBS coupon, and thus essentially the underlying loan rates, Alan is not quite right, and the negative convexity is similar to that of a callable fixed rate bond. With the primary caveat that individual borrowers may have even more reasons for exercising their prepayment options “non-rationally” than a corporate treasurer.
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Re: Why is there prepayment risk for a TBA?

February 4th, 2021, 5:58 am

Maybe a real example would help

UMBS 30Yr March 2.5 TBA   

Pool = a basket of individual mortgages.  It is tradable, but less liquid than a TBA.
UMBS =  Fannie Pools and Freddie Pools with payment delays equal to Fannie Pools  (UMBS cutover was in Jun-2019)
March = Delivery Date where you need to deliver a TBA-eligible UMBS pool.
30Y = short for 'fixed rate 30 year mortgages'
2.5 = Net Coupon that the pool pays.  Actual mortgage rates that are in the pool will most likely be distributed around 2.8 - 3.2

So if you think about each of the individuals in the pool,  each one of them has the option to prepay their mortgage.  They do this for a variety of reasons: they move from house to house,  they extract equity out of their home's value with a cash-out refi, or interest rates have dropped enough below the coupon they are paying to allow them to save lifetime interest or lower their payment, etc.

For this demonstration, just focus on the refi-for-lower-rate reason for prepayment.

The key thing to note here is that the above TBA contract I mentioned was on Fannie/Freddie pools that pay a net rate of 2.5 percent.    This is simply part of the contract and is fixed, yet mortgage rates that borrowers can transition into is changing each day.

Let's say next week the 10yr treasury drops 150 basis points.   30y Fixed Rate Conventional Mortgage Rates will also drop.  Maybe not by 150 basis points as there is a dynamic spread between the 10yr treasury rate and 30yr fixed mortgage rate, but it is pretty correlated.  

Now, each of the individual mortgages with loans that back the actual 2.5 pools (TBA-eligible pools) that can be delivered to this TBA contract will now have some increased prepay risk as the borrowers can just go on RocketMortgage and lock in a new rate pretty quickly.   Since all of the 2.5 pools have prepay risk, so does the generic 2.5 TBA contract since you would be delivering these actual pools into the TBA on the expiration/delivery date.

So this is why the 'UMBS 30Yr March 2.5 TBA' contract has prepayment risk.

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Re: Why is there prepayment risk for a TBA?

February 4th, 2021, 1:25 pm

That is clear and helpful.