The Treasury Market Practices Group, which the Federal Reserve Bank of New York helped form in 2007 to offer advice on debt markets, today proposed the charges. That followed the introduction of a similar practice for U.S. government bonds that the organization backed in 2009.

The U.S. central bank’s decision to hold benchmark interest rates at record lows has encouraged failures by reducing the cost of uncompleted trades, while its purchase of $1.25 trillion of mortgage bonds through March 2010 has made it more difficult to find bonds to settle contracts in a timely manner.

“We strongly believe that, like the fails charge recommended by the TMPG in the Treasury market, these recommendations will lead to more robust markets for agency debt and agency MBS and will serve to broadly reduce the risks associated with high levels of fails,” Tom Wipf, the group’s chairman, said in an e-mailed statement.

Uncompleted trades in agency mortgage securities remain elevated after rising to a record of almost $2.4 trillion during a week in November, according to Fed data.

Failures to receive or deliver the securities, which totaled $1.5 trillion in the week ended April 20, averaged about $330 billion weekly over the past 10 years, according to Fed data. The tallies are inflated by incomplete trades that continue over multiple days and are increased by strings of failures that can occur when a single party doesn’t settle a contract.

New Charges

The new charges could be as much as 3 percent of the trade size, with the formula based on a similar system for U.S. government debt, said Wipf, also a Morgan Stanley banker, in a telephone interview. The daily charge would be reduced by the Federal Open Market Committee’s lowest current target for the federal funds rate and divided by 360.

“The fail charge is too high and will be counter- productive,” Scott Simon, Newport Beach, California-based Pimco’s mortgage-bond head, said in an e-mail. “While it will reduce intentional fails, we believe it will sharply reduce liquidity and incent accounts to attempt short squeezes.”

A 1 percent fee “would be a much better level,” said Simon, whose firm manages the world’s largest bond fund.

Short Squeeze

A short squeeze refers to hoarding of bonds that may be needed to be bought to complete trades.

The TMPG suggested a two-day grace period for failures in the more than $5 trillion market for agency mortgage securities, which are guaranteed by government supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae. Agency debt includes the corporate bonds of Fannie Mae, Freddie Mac and the Federal Home Loan Bank system, which have more than $2 trillion of outstanding borrowing.

The TMPG in July proposed market practices intended to curb failures that stopped short of penalties. It’s soliciting comments on the charges through June 10, and expects to implement changes in early 2012.

Reducing uncompleted trades is necessary because for individual companies, “fails can increase operational costs and counterparty credit risk, absorb scarce capital through regulatory charges, and damage customer relations,” the TMPG said in a paper released today.

“More generally,” the group added, “the prospect of persistent settlement fails at a high level can cause market participants to temporarily withdraw from the market, or even exit the market, adversely affecting market liquidity and stability.”

Lower Rates

The Fed’s decision to hold its target for the federal funds rate in a range of 0 percent to 0.25 percent since 2008 has helped encourage fails because it lowers the cost of not receiving cash in exchange for the promised securities. In a higher-rate environment, dealers would lose more because that cash could be invested at higher yields.

Lower rates boost the incentives for investors or dealers that want to “short,” or bet against, mortgage-bond prices to delay delivering bonds into sales contracts, according to the group’s paper.

Most transactions in the mortgage-bond market are conducted through so-called To Be Announced trading, which also adds incentives to fail on those contracts. TBA contracts can be filled through delivery of securities with a range of characteristics, rather than specific bonds.

That gives dealers and investors a motive to wait until they acquire “less valuable” securities before completing trades, according to the industry group’s paper.