MBS Market Technical Factors: Dollar Rolls


Previously we discussed the technical factor convexity. 
Another set of technical factors that impact secondary managers are in
the dollar roll market that we discussed a few weeks ago.  Dollar rolls
(i.e., the price difference between the same security for different
months’ delivery) are impacted by a number of factors.  First consider
the different participants in the MBS markets.  Originators are
generally selling their production for later months, given the factor
that rate locks are taken under the understanding that the loans will
fund at some point in the future.  That means that there is systemic
selling pressure in the later (or “back”) months.  

Alternatively, some investors (such as banks) want to buy MBS for early settlement,
since they can only begin to accrue coupon earnings once they own
settled securities.  Finally, CMO desks (i.e., the units in
broker/dealers that structure and market agency CMOs) have a structural
need to buy various types of agency passthroughs for current-month
settlement in order to settle their deals.  (That’s why CMO traders
refer to passthrough pools as “collateral;” to them, they’re just fodder
for deals.)

The combined impact of back-end selling and early-month demand means
that dollar roll levels are often rich (or “special”) to where they
should trade based on fundamental factors such as funding rates and
short-term prepayment speeds.  The specialness of rolls is often
exacerbated during periods of heavy issuance of MBS and/or CMOs.
 Investors that have the option of buying front- or back-month
settlement (such as money managers) can often take advantage of dollar
roll specials to effectively gain cheap financing for their MBS
holdings.  (I’ve had investors tell me that dollar-roll levels were the
single biggest factor in choosing what MBS coupons to hold.)

The other factor impacting rolls, which is important to secondary
managers, is the fact that rolls far out in settlement often trade
erratically.  Broker screens often will show three delivery months,
i.e., the current month, plus the next two back months.  That means that
up until notification day, the current month and the next two months
will be on the screen.  For example, levels for February, March, and
April were shown as a delivery month until after last Thursday (2/9);
after that, February was removed and May was added.  Prices for May then
moved roughly back in line with other months; April/May rolls went from
trading at around 14/32s to around 10/32s.

This means that secondary managers that sold TBAs for May settlement
simply because they had a lot of long-term locks in their pipelines
traded inefficiently.  It would have been much better for them to have
continued to sell April TBAs until May actually were added to broker and
TradeWeb screens.  At that point, they should look at their pipelines
and adjust their positions to account for their expected fundings for
each month.   A healthy respect for the market’s technical conditions
will often help lenders improve their hedging efficiency and secondary

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