Trade allocation involves allocating a forward trade to a third party, commonly used in mortgage-backed securities transactions to avoid delivery of securities and control trading activity. It carries risks but can generate income and reduce risk for home loan originators.
A trade allocation is a term used to describe a situation where one of the parties involved in a forward trade decides to allocate that trade to a party that was not part of the original deal. The use of this particular approach is most common with transactions involving mortgage-backed securities that are part of a To Be Announced Market (TBA) transaction, and are generally employed when there is a desire to avoid delivery of the securities. involved or to move by making a delivery of those values. This type of strategy can also be employed as a means to eventually exchange all of the relevant assets involved with a loan to that outside party, who in turn makes a pact to arrange a delivery at the original trade to be announced.
The underlying purpose of a trade allowance is generally to control how and when the trading activity of the assets associated with a loan will be delivered on a TBA market. This is sometimes necessary to ensure that the maximum amount of return from the deal is generated, while avoiding increasing any additional risk to the parties involved in the original deal. By involving a third party in the arrangement, it is easier to manipulate the delivery of one or more of the securities backing the mortgage loan, both in terms of receiving and issuing that delivery. In the best of circumstances, the strategy helps to forgo a loss that would otherwise have occurred, while still providing the latter party to the deal to receive some sort of benefit from the deal.
The strategy of a trade allocation goes beyond simply selling one of the underlying securities to a third party. Typically, the agreement will include an agreement by the current holders to sell entire loans to that third party, who in turn also agrees to purchase those entire loans. A home loan originator can use this process to effectively reduce the risk associated with holding the loan, while the buyer has the opportunity to use the transaction to generate a steady stream of income from owning those associated mortgage-backed securities. with the acquired loans
Like any type of investment strategy, a trade allocation carries some degree of risk. Defaulting on mortgage loans associated with the securities can spell loss for whoever currently owns those assets. This means that if the assignment of the operation is completed when the mortgages involved default, it is the third party that ultimately suffers the loss. At the same time, if those mortgage-backed securities are associated with loans that have variable or floating interest rates, there is also the possibility that that investor will enjoy a higher return than originally anticipated.
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