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Several mortgage-backed securities (MBS) occur in forwarding markets called TBA where the seller agrees on the sale value but he does not specify which securities will be delivered to the buyer on the settlement day.
The government guarantee removes credit risk which lowers the feasibility of the market but these are not considered low-risk securities.
Just like the treasury futures, it trades on the cheapest where the seller has a strong incentive to select the securities of the lowest value and quality, like the one with higher prepayment risks or geographical traits.
A few basic characteristics of the securities that are agreed upon like coupon rate or the face value of bonds can be delivered. The one less known feature is the liquid forward.
It is the kind of trading that helps to transform the essential heterogeneous set of individual underlying mortgages for a large set of easily substitutable MBS pools and this drives the TBA market’s liquidity.
It offers tremendous market liquidity, hence, counterpart risk may not be an issue but during distressed times it can create problems due to the repo nature of currency exchanges.
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