What Are Mortgage Allocations?

Mortgage allocations are a step in the settlement of to-be-announced mortgage-backed securities (MBS) that are traded in the secondary market. At assignment, the seller provides the buyer with the precise details of the loans that make up the underlying pool of the MBS.

Key Takeaways

  • Mortgage allocation refers to a step in a to-be-announced mortgage-backed security (MBS).
  • This step is when the seller of the MBS notifies the buyer with all of the details of the underlying mortgages that make up the MBS.
  • The mortgage allocation process occurs in the secondary market for traded mortgage-backed securities (MBS).
  • At the time the trade is executed, neither the buyer nor the seller is aware of the underlying mortgages in an MBS; this is to ensure trading and liquidity.
  • The seller must notify the buyer of all of the underlying mortgage details two days prior to settlement of the trade by 3 p.m.
  • The variance between the estimated value of the underlying loans and the final allocation of the underlying loans has a restriction value that is set at 0.01% of the price of the trade.

Understanding Mortgage Allocations

Mortgage-backed securities (MBSs) are financial securities created by pooling multiple mortgages into a repackaged security and selling them to an investor. The buyer of an MBS receives a stream of income from the interest payments made by homeowners on those mortgages.

When an MBS is traded in the secondary market, the underlying mortgages that make up a specific MBS are unknown. Mortgage allocation is the process by which a seller of a mortgage-backed security (MBS) details the mortgages that make up the to-be-announced (TBA) MBS by a certain date and time.

Mortgage Allocation Process

When a buyer and a seller agree on a TBA trade, they fundamentally agree to the terms of a contract. The parties agree on the issuer, maturity, coupon, price, and par amounts of the traded securities. Beyond these criteria, the underlying loans are considered interchangeable. That also means that the buyer and seller are not aware of the quality of the underlying mortgages in the MBS.

This interchangeability facilitates trading and liquidity in the secondary market. The buyer and seller also agree on the date of settlement for the trade. Two days before the settlement date, by 3 p.m., the seller has to notify the buyer of the exact pool of mortgages included in the MBS. Allocation of specific mortgages to the traded security happens in this period before delivery, which is known as mortgage allocation.

Approximately 90% of Freddie Mac, Fannie Mae, and Ginnie Mae mortgage-backed securities trade on the TBA marketplace. This makes it the most important secondary market for mortgage securities. It is second only to the U.S. Treasury market in fixed-income trading volume and is subject to rule-making by the Security Industry/Financial Market Association (SIFMA).

Mortgage Allocation Guidelines and Non-TBA Trading

The value of TBA trades is not known at the time of execution so are instead estimated, therefore, the final allocation of mortgages is subject to variance between the actual amount and the estimated amount. There is a variance restriction imposed by the Securities Industry and Financial Markets Association (SIFMA). This restriction is a means to ensure the interchangeability of the underlying mortgages and is set at 0.01% of the price of the trade.

The mortgages that will be delivered on the settlement date must satisfy the agreed-upon trade within the boundaries of that requirement. In the past, variance limitations were more lenient and allowed traders an arbitrage opportunity when allocating mortgages at the notification date. As SIFMA has tightened its variance allowances, this is less common. Advanced software has allowed traders to satisfy tighter variance guidelines.

Traders looking to avoid the allocation process have the option of placing non-TBA trades in the specific pool market. In these transactions, the buyer and seller agree to trade particular mortgage pools and no subsequent allocation is required. The loans sold in this market tend to be of classes that do not meet SIFMA’s definition of standard loans. Among these can be interest-only loans, 40-year mortgages, or adjustable-rate mortgages (ARMs).

Example of a Mortgage Allocation

Mary decides to sell Peter a mortgage-backed security (MBS) and Peter decides to buy it. They both agree the sale will take place on Tuesday. When the sale is executed, neither Mary nor Peter know the types of mortgages that make up the MBS. The standard settlement is T+3, meaning the trade will settle on Friday. Per the two-day rule, Mary reaches out to Peter on Wednesday before 3 p.m. and notifies him of the mortgage allocations he will receive when the trade settles on Friday.