The Treasury Market Practices Group ("TMPG") of the New York Federal Reserve recently recommended that forward-settling agency MBS transactions be bilaterally margined (i.e., market participants should exchange two-way variation margin) in order for market participants to prudently manage their counterparty exposures. In support of the recommended best practices, the Securities Industry and Financial Markets Association published a new form of Master Securities Forward Transaction Agreement (the "2012 MSFTA") making a number of amendments to the previous form published in 1996 to implement the recommendations.
While the TMPG had initially encouraged dealers to implement these recommendations by early June 2013, it provided some relief earlier this year by recommending that market participants substantially complete the process of margining forward-settling agency MBS exposures by December 31, 2013.
Major dealers have started reaching out to market participants in order to negotiate the 2012 MSFTA and replace the agreements under which these transactions had typically been documented on an uncollateralized basis.
The TMPG recommends that the bilateral margining practice, at a minimum, apply to four broad categories of agency MBS transactions: collateralized mortgage obligation transactions settling later than T + 3, and To-Be-Announced, specified pool and adjustable-rate mortgage transactions settling later than T + 1.
Delivery Fails Charge
Under the 2012 MSFTA, upon a delivery failure by the seller at settlement, the buyer may elect to require the seller to pay a "fails charge" (under the previous form the only remedy for a delivery failure is termination of the entire facility). The practices allow for the buyer to charge the seller a fee (fails charge) for each day the delivery failure continues and provides a mechanism for fails charge calculations. This financial charge is expected to provide an incentive to sellers to deliver securities in a timely fashion and thereby reduce overall fail levels.
Events of Default and Close-out Mechanism
The 2012 MSFTA provides market participants with greater flexibility to customize termination provisions as follows:
- in case of a delivery failure, the buyer can close-out just the defaulted transaction (as opposed to the entire facility); and
- some events of default have been made optional, some others have been made subject to cure periods and continuity requirements and automatic early termination for insolvency events can now be made optional through a mere election in the annex.
The liquidation mechanism used in other master agreements for structured products (e.g., ISDA or MRA) has been adopted together with related calculation methodology and standards.
Market participants should carefully review and customize the margining and termination provisions of this new agreement to fit their risk appetite and maximize their flexibility in the event of a default by their counterparty. As with most other financial market transaction agreements, the 2012 MSFTA may also have collateral and cross-default impact on other trading facilities and should be adequately insulated to prevent contagion.