In the latest attempt to create a new market for mortgage-related securities, the Chicago Board of Trade will initiate trading on mortgage futures and options Friday.
The board is marketing the contracts to mortgage-related companies as alternative hedges on originations and servicing, to investors such as speculators and fund managers, or to anyone seeking exposure to mortgage-backed securities who does not want to hold the cash.
The market will be based on an index created by the Chicago Board of Trade, which will track three Fannie Mae and three Freddie Mac securities to assign coupons to the index. The futures will trade on a monthly expiration cycle and be settled in cash.
Investors will essentially buy the cheapest, most current coupon available of 30-year Fannie and Freddie mortgages, said Daniel Grombacher, a senior economist at the Chicago exchange. The contracts, which will hold $100,000 face values, will be based on a pool of mortgages.
Though many in the mortgage business already use forward markets or other instruments to hedge against risk, such as Treasury futures or Eurodollars futures, the board of trade says the $2.3 trillion mortgage-backed security market is the worlds largest cash market without a corresponding futures contract and thus ripe for the boards new product.
Julie Winkler, advisory economist at the board, said the securities were created primarily to be another hedge vehicle for cash market participants. She said that because mortgage-backed securities do not have a futures market, the new product is a natural for the Chicago exchange.
This market allows people to hedge what they might already have in the cash market, and they can protect their investments, she said, calling it a form of insurance.
You could take the opposite position in the futures market and protect that from dramatic price changes that may occur, Ms. Winkler added.
Bill OGrady, an analyst with A.G. Edwards & Sons, said there have been almost a dozen attempts at creating this market over the years. These failed, he said, because the markets could not create adequate liquidity and faced stiff competition from the forward market and other instrument hedges.
He said the futures exchanges, in their product-development campaigns, take a pound of spaghetti, throw it against the wall, and if one of them sticks, it gets to stay. The rest fall on the floor and get swept up.
Ms. Winkler acknowledged that new products on the Chicago Board of Trade have a 90% failure rate, but she said primary dealers and originators seem pretty excited about this one.
Mr. OGrady did say the new indexs cash settlement model is a departure from previous tries. Further, he said, investors and financial firms have grown increasingly concerned about using Treasury notes as a hedge instrument.
If Treasury debt continues to erode as the government runs surpluses and pays off debt, Mr. OGrady said, that market could disappear.
That might help this contract a lot, because it would be seen as an alternative to speculating and hedging in long-dated interest rates, he said.
Though board of trade officials agree that liquidity is crucial to the new market, Mr. OGrady said its fate is also very much in speculators hands institutions and the industry involvement alone will not make it fly, he said.
The trick to this working is going to be, Will the speculative players want to get involved? Thats what makes a market go. You have to have a large number of speculative players and commercial players. If you get both in a market, that will work.