A proposal by the Financial Industry Regulatory Authority designed to reduce counterparty risk in the forward market for mortgage bonds troubles some market participants, who say that the measures could have the opposite effect.

At issue is the to-be-announced market, where investors and lenders agree to buy or sell mortgage backed securities on a future date. When these trades take place, the specific pool of mortgages that will be delivered to fulfill the contract is unknown. Parties agree only on the issuer, coupon, price, product type, amount of securities and settlement date. TBA sales allow originators to hedge their interest rate risk and efficiently lock in interest rates for loan applicants throughout the origination process.

Unlike other kinds of forward markets, such as swaps, futures or listed options, there have traditionally been no requirements that TBA participants post collateral to offset the risk that they might fail to deliver. The resulting counterparty risk is exacerbated by the length of time between execution and settlement. So, for example, if a purchaser defaults and there has been a swing in interest rates, the selling loan originator could get a less favorable price.

In January, FINRA published proposals designed to address this risk by, among other things, establishing margin requirements for transactions in the TBA market and setting timeframes for the collection of margin and required liquidations. Today is the deadline for commenting.

FINRA's proposal came on the heels of a set of best practices adopted by the Treasury Market Practices Group of the Federal Reserve Bank of New York.

The Association of Institutional Investors, which represents hedge funds, mutual funds and other investment advisers, released a statement this morning outlining its concerns.

"We commend FINRA for attempting to update its rules in response to perceived market risks," Joe Sack, staff advisor to the association, stated in a press release. "However, we are particularly mindful of the potential unintended consequences that may result from FINRA’s proposed amendments."

"Fewer participants in these markets will lead to reduced demand and lower liquidity," Sack said. "Reduced liquidity in the agency MBS market, in particular the TBA market, will cause a meaningful increase in hedging costs for mortgage originators which, in turn, will mean higher borrowing costs for American homebuyers."

In its letter, the association also recommends that FINRA conduct further analysis of the impact of agency MBS margining and continue to evaluate how best to harmonize the FINRA proposal with the TMPG margining recommendations.

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