Forward Settlement – of Ideas

I’ve recently taken on an assignment for Financial Planning magazine, a monthly that goes to – you guessed it – financial planners.  I’ll be writing about mortgage REITs, a topic I’ve been “up” on for more than twenty years.

Given the mREIT coverage by the entire main stream of the financial press (Forbes online has a piece today, and the Wall Street Journal gave them a full half page earlier this week), the challenge is to say something now that will still be relevant when the magazine comes out on December 1st.

It’s not unlike the problem Cypress Sharpridge (CYS) had trying to explain its strategy of forward purchases for its MBS, and how they could actually make a profit on something they didn’t own yet.

So here’s how I plan to attack the problem:  by explaining the business model the way a bond guy understands them.

When CYS allocated a big chunk of their December equity capital raise on MBS purchases that wouldn’t close for weeks or months into the future, the financial reality is that a buyer “owns” that yield once the trade ticket is written.

This is business as usual for bond traders, yet even this ordinary fact of the bond market continues to be some kind of dark mysterious magic to most stock jocks.  Even more frightening to most people looking at Cypress Sharpridge was the amount of leverage apparently being used.

CYS committed to forward purchases totaling $2.234 (purchase price) with their $167 million of new cash.  On the face of it, that looks like leverage north of 12-1!

But it wasn’t, really.

You see, CYS already owned nearly $3 billion of MBS before they made those forward purchase commitments.  Assuming a modest prepayment rate averaging 1% per month, they were expecting to get roughly $120 million of principal back over the first four months of 2011, so the leverage ratio was really more like 7-1.

Before I let this go, let me explain the business of forward settlement “profits” in an analogy to a much more common investment we all understand – Treasury Bills.

For new debt less than a year in maturity, the Treasury issues T-Bills, and Bills never have coupons.  Instead, they are priced at a discount, and the effect is to pay a positive yield by paying par at maturity.  Same thing with forward purchases of MBS.  If a 30-year 4% MBS costs 104.25% today for an expected yield of 3.30%, then a 4% MBS that settles a month from now has to cost less so it “pays” the buyer that yield for the month after they commit their capital.  In that way, it’s the same as the lower prices on six-month Bills than the price for three-month T-bills that we see when the yield on T-Bills is greater than zero.  (Who would have thought a few years ago that I would have to make that qualification that it only happens when yields are positive?)

Anyway, I’m looking forward to working on this assignment over the next couple of weeks, and hopefully it will help those financial planners understand these beasts, and how they fit in their clients’ portfolios.

Why not add my voice to the mREIT chorus, now that everyone and his brother-in-law seems to have discovered them?


One Response to Forward Settlement – of Ideas

  1. Bill Bachand says:

    Congrats on the new assignment Howard. And thank you for the well explained post. I always admire your way of putting a complex subject into words that most laymen can understand. I really appreciate your blog.

    Bill Bachand

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