Mortgage Allocations

Mortgage allocation is a step in settlement of to-be-announced trades on mortgage-backed securities. At assignment, the seller provides the buyer with precise details of the loans that make up the underlying pool of the security trading.

Mortgage allocation is the process by which a seller of mortgage-backed securities (MBS), details the loans which make up security traded on the to-be-announced (TBA) market. Approximately 90-percent of Freddie Mac, Fannie Mae, and Ginnie Mac pass-through securities trade on the TBA marketplace. This trade 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 rulemaking by the Securities Industry and Financial Markets Association, known as SIFMA.

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. This interchangeability facilitates trading and liquidity on the secondary market. The buyer and seller also agree on the date of settlement for the trade. Two days before settlement, on the notification date or 48-hour day, the seller notifies the buyer of the of the exact pool of securities included. Allocation of specific mortgages to the traded security happens in this period before delivery. This step is known as mortgage allocation.

Allocation is subject to 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 percent per $1 million in bonds. 

The mortgages which will be delivered on 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.