How a 48-Hour Rule Works

The 48-hour rule essentially compels anyone selling specific mortgage-backed security (MBS) to inform the buyer of the mortgages that make up the MBS some 48 hours before concluding the trade. This usually happens as part of a TBA trade day after the parties begin the trade at 3 p.m. eastern time. TBA is a promise to sell or buy MBSes on a certain date.

A mortgage-backed security is primarily a secured or mortgage-backed bond. Generally, mortgage loans that share similar traits form a pool in a group. Investors can then buy these pools as security. What the seller issues investors as principal payments and interest are determined by what borrowers of the underlying mortgages pay to the lender. Investors usually receive monthly interest payments rather than semi-annual payments.

Ordinarily, SIFMA (Securities Industry and Financial Markets Association) enforces the 48-hour rule. The authorities use the 48-hour rule as part of the process of mortgage allocation. During this period, the underlying mortgages are assigned and availed to a specific MBS. They create this to introduce transparency to the TBA-model trade agreements or settlements.

48-Hour Rule Example

Company XYZ has decided to sell an MBS (mortgage-backed security) to company ABC, and the latter accepts. They arrange to have the sale on Tuesday. On the trading day, neither company XYZ nor company ABC know about the underlying mortgages making up the MBS.

Since the standard industry settlement stands at T+3 days, it means the parties will settle this trade on Friday. But according to the 48-hour rule, company XYZ must notify company ABC of the mortgage allocations it can expect to receive when the trade finally settles.

Significance of a 48-Hour Rule

The 48-hour rule is beneficial to both buyers and sellers as an essential segment of the TBA (to-be-announced) Process. It helps buyers and traders of the TBA to reach an agreement on the necessary parameters, including price, coupon, settlement date, issuer maturity, and par amount. This is because the dealers announce the securities involved 48 hours before they finalize the agreement or settlement.

Overall, the TBA trade works as a contract made to buy or sell the MBS (mortgage-backed securities) on a set date. It doesn't usually include information about the pool number, the exact amount factored in the transaction, and the precise number of pools. This means that the parties are unaware of the underlying mortgages resulting from the exclusion of data. Thus, the MBA pools are generally interchangeable. The 48-hour rule and the interchangeability element are potent agents that facilitate liquidity and trading.

When the parties trade the MBS in the secondary market, they typically do not know the underlying mortgages. A secondary market is where investors sell securities they already own, like the New York Stock Exchange. This facilitates trading. It also increases the MBS market liquidity by taking different mortgage-backed securities with varying characteristics and using several contracts to trade them.