- For purposes of lowering mortgagor borrowing costs, building a stronger banking system through more efficient hedging of mortgage risk and encouraging additional capital to enter the mortgage sector, we believe there is ample reason to include a mortgage current coupon yield index as one of the alternative indices to LIBOR
- Now that protective guidelines by self-regulating bodies have been put into place, it is reasonable to assume that financial and civil/criminal penalties for the next crisis involving financial index reporting and misalignment of interest (real or perceived) will be far harsher
- MIAC has developed an IOSCO compliant TBA Pricing Service providing Level 1, 2 and 3 prices for the entire TBA market including all contract months as well as their associated Current Coupon Yields (CCY) fixings. These prices and yields are fully transparent and provided hourly
Recent headlines returned a sharp focus to the specter of shadow banking, opaque valuations and misalignments of interest that result when market agents are left unchecked. Just as homeowners and savers had begun to see their personal balance sheets heal from the subprime crisis and its associated equity market contagion, they learned in July 2012 of something known as The LIBOR Scandal. On July 27, 2017, things became even more interesting as the UK’s Financial Conduct Authority (FCA) announced that it would no longer guarantee the existence of LIBOR after 2021 due to lack of trading activity in certain maturities. That’s when homeowners and savers alike awoke to the story.
It’s worthwhile to get a sense of the stakes at hand. Misstatements of LIBOR may have amounted to no more than approximately a single basis point on any given fixing and overtime must have been overwhelmed by larger factors moving the markets. Nevertheless, this was enough for one prominent finance academic to characterize it as the “largest financial scam in the history of markets by an order of magnitude” affecting perhaps as much as $800 trillion dollars of investment contracts . There have been more than $9 billion of fines against global banking titans such as Deutsche Bank, Barclays, and UBS for their role in this fiasco with more than a dozen convictions and pending legal actions .
In response to the LIBOR Scandal, The Board of the International Organization of Securities Commissioners (IOSCO) published the Principles for Financial Benchmarks (“the Principles”) in July 2013 . This is a roadmap of best practices intended for all markets, i.e. equities, fixed income, currencies, and commodities. The Principles are a detailed 45-page document that lays out 19 guidelines covering Governance, Methodology, and Transparency.
Quite appropriately, the first Principles discussed in the document are good governance practices. The most important takeaways are the following. The index must have an Administrator with overall responsibility for the index itself and oversight of third-party products and services used in index construction. The Administrator cannot be tainted by conflicts of interest or the appearance of conflicts of interest. And the use of opaque valuation techniques oftentimes called “expert judgement”, is strongly discouraged.
The other overarching theme of the Principles is transparency. The gold-standard for publication of financial indices/benchmarks is to use transaction data whenever available. Certainly, the Principles recognize there are times when recent transaction data is not available for a financial asset held within an index. In those instances, various methodological prescriptions are available. However, clearly, the best solution is to use either a recent transaction for a close surrogate asset or a clear and robust valuation formula that is itself directly tied to transaction data.
How does all this relate to LIBOR and ultimately to the mortgage market? We turn to those questions next. Arising out of The LIBOR Scandal and in response to recommendations from the Treasury’s Financial Stability Oversight Council (FSOC) and the global Financial Stability Board (FSB), the Federal Reserve Board together with the New York Fed convened the Alternative Reference Rates Committee (ARRC) on November 17, 2014. The mandate of ARRC is “…to promptly identify alternative interest rate benchmarks anchored in observable transactions and supported by appropriate governance structures…” and again later in the same section “…to identify a set of alternative reference interest rates that are more firmly based on transactions from a robust underlying market and that comply with emerging standards such as the IOSCO Principles for Financial Benchmarks…” . It’s clear from both passages that the mandate calls for the identification of more than one benchmark as a replacement to LIBOR. This is because applications of LIBOR developed over many years until they became almost ubiquitous, used in a myriad of ways. It is unlikely that a single replacement index will serve all purposes for which LIBOR has grown to be used.
As one replacement index for LIBOR, we believe the markets would benefit from the creation of mortgage benchmark TBA Prices and associated Current Coupon Yield (CCY) Indices created under IOSCO Principles. We offer below three brief examples for consideration addressing needs of homeowners, mortgage servicers and institutional investors. We offer three brief examples for consideration addressing needs of homeowners, mortgage servicers and institutional investors.
A More Transparent and Robust Mortgage Current Coupon Yield (CCY): Application Examples
- The use of LIBOR as an index in adjustable rate mortgages (ARMs) might be considered one such example. LIBOR is a short money market rate, but when packaged with a large margin into ARMs, it is used to reflect borrowing alternatives at a much longer point on the yield curve. Creating ARMs indexed to the mortgage current coupon yield index would reduce the measurement risk in hedging these mortgage portfolios. This would have real-world implications for efficiently hedging ARM portfolios, in fact for hedging all high-grade mortgage portfolios where mortgage basis risk represents the largest risk factor. Better hedged returns for lenders will translate into lower borrowing costs for homeowners over time.
- The mortgage servicing rights (MSR) market is an example where the creation of an investible CCY under best practices could have significant benefits to market participants. Perhaps more than any other asset, MSR prices are heavily tied to the movement of CCY. Current practices use imperfect hedges such as LIBOR-based swaps, swaptions, Treasuries, and TBAs to hedge servicing portfolios. Creation of more liquid hedge instruments closely tied to their primary risk exposure could allow servicers and depositories to better manage their balance sheet.
- Lastly, creating investible index products tied directly to CCY would allow institutional and retail investors alike to gain exposure to the mortgage markets via ETFs or index funds that would not have the prepayment risk (aka “fat tail risk”) associated with traditional actively managed mortgage portfolios. This could attract additional capital to enter the mortgage market and allow institutional investors to have a complete construction of the market portfolio.
But aren’t there already TBA prices and CCY indices published on Bloomberg and elsewhere? Yes, however, these prices and indices suffer from all the issues that IOSCO was created to address. We have written about this elsewhere and provided data supporting these thoughts . We summarize here that TBA prices and the CCYs published on Bloomberg and other sources face the following challenges:
Nevertheless, haven’t there been some OTC contracts written on these CCY indices called Constant Maturity Mortgage (CMM) Swaps to hedge the mortgage basis? Yes, however, there has also been some history of litigation over disputes of the CCY settings used in valuing them. Not surprisingly, the adoption of these valuable hedging tools has been muted for the same reasons that afflict CCY. This is another testament for the need for a more standardized TBA Price and Yield methodology.
As the ARRC undertakes to evaluate “a set of” alternative indices to LIBOR, now is an opportune time to take the long view and prepare for market cycles that lie ahead in the growth of the mortgage market. For purposes of lowering mortgagor borrowing costs, building a stronger banking system through more efficient hedging of mortgage risk and encouraging additional capital to enter the mortgage sector, we believe there is ample reason to include a mortgage current coupon yield index as one of the alternative indices to LIBOR.
MIAC has developed an IOSCO compliant TBA Pricing Service providing Level 1, 2 and 3 prices for the entire TBA market including all contract months as well as their associated CCY fixings. These prices and yields are fully transparent and provided hourly. Level 1 prices are based on TRACE transactions. Level 2 and 3 prices are based on robust spread relationships and rules that are also directly transaction-based and have been market tested. MIAC has published a brochure on its TBA product available upon request .
MIAC has also begun publishing Case Studies of their TBA Price and Yield indices . Among other topics, these studies will address well-known weaknesses from other pricing sources that are addressed in the MIAC pricing methodology. They will also show trading and liquidity characteristics for premium/discount coupons and cash/forward contracts important to various market participants.
 http://www.accountingdegree.net/numbers/libor.php “The LIBOR Scandal Explained” The quote is attributed to Andrew Lo, Professor MIT
 https://www.newyorkfed.org/arrc See section under “About Us”.
 “The MIAC TBA Pricing Product” Published by MIAC Analytics
 “The MIAC TBA Pricing Product: Case Study #1 – Bid/Offer Spreads as a Function of MIAC Prices” and “The MIAC TBA Pricing Product Case Study #2 – A Comparison of MIAC & Bloomberg Current Coupon Yields” are the first two publications in this series.
K. Daniel Libby, CFA, Senior Vice President, Capital Markets Group
MIAC Perspectives – Fall 2017
Mortgage Benchmark Prices and Yields in a Post-LIBOR World