What is a Drop?
Drop, also known as the roll price, is the difference in price between settlement months when executing mortgage-backed security (MBS) dollar roll trade. Similar to a repurchase agreement, dollar roll trades serve as the primary channel for mortgage security borrowing and lending in the to-be-announced (TBA) market. Specifically, the drop is the price difference between when the investor sells the MBS and repurchases it at a later date.
BREAKING DOWN Drop
The drop is a price spread between the current month and a future month for a pool of mortgage-backed securities. Spread is the difference between the bid and the asking price of a security or asset.
The drop sees primary usage in the to-be-announced (TBA) marketplace. This marketplace is where forward-settling mortgage-backed security (MBS) trades settle. The term TBA is derived from the fact that the actual mortgage-backed security that will be delivered to fulfill a TBA trade is not designated at the time the trade is made. The securities are announced 48 hours prior to the established trade settlement date.
To-Be-Announced Market and Drop
Pass-through securities issued by Freddie Mac, Fannie Mae and Ginnie Mae trade in the TBA market. A pass-through security is backed by a bundle of underlying assets, such as mortgages. A servicing intermediary collects monthly payments from issuers and, after deducting a fee, remits or passes them through to the holders
Within the TBA market, there may also be dollar roll transactions in pass-through securities. In these trades, the buy-side agrees to sell off in the current month and buy back in a future month. The price difference between months is known as the drop. When the drop becomes very large, the dollar roll is said to be "on special". This special designation is due to the investor being able to maintain mortgage exposure and invest and earn interest on the proceeds from the sale of the MBS.
Variations on the traditional dollar roll trade involve purchasing similar securities, rather than identical securities during the first purchase.
The size of the drop is influenced by demand for mortgage pass-through securities and the volume of mortgage closings in a mortgage originator’s pipeline. If a financial institution has more sell trades in a given month than what they can deliver securities for, they will need to roll those trades into a future month. The lower the number of available securities in a given month, the higher the drop, or the spread in price differences, will be.
The drop is quite often positive, due to the economic value of taking delivery of the mortgage-backed security (MBS) and enjoying the revenue generated from interest or principal payments.
Pros and Cons of the Drop
Both buyers and sellers can profit from the drop. The buy-side counterparty gets to invest the funds that otherwise would have been required to settle the buy trade in the current month until the agreed upon future buy-back. The sell-side counterparty benefits by not having to deliver the pass-through securities, which they might otherwise have shorted or committed to another trade, in the current month.
An excellent way to examine the economic benefit of a dollar roll transaction, and the resulting drop, depends on if settling the MBS and earning the coupon income, or deferring settlement into the next month and earning the cash return, will be the best use of funds.