Cheapest-to-Deliver Pricing, Optimal MBS Securitization, and Market Quality

Yesol Huh and You Suk Kim
Additional contact information
Yesol Huh: https://www.federalreserve.gov/econres/yesol-huh.htm
You Suk Kim: https://www.federalreserve.gov/econres/you-suk-kim.htm

No 2021-031, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We study optimal securitization and its impact on market quality when the secondary market structure leads to cheapest-to-deliver pricing in the context of agency mortgage-backed securities (MBS). A majority of MBS are traded in the to-be-announced (TBA) market, which concentrates trading of heterogeneous MBS into a few liquid TBA contracts but induces adverse selection. We find that lenders segregate loans of like values into separate pools and tend to trade low-value MBS in the TBA market and high-value MBS outside the TBA market. We then present a model of optimal securitization for agency MBS. Lenders do not internalize the negative impact of such pooling and trading strategies on TBA market quality and thus create too many high-value MBS, which leads to more heterogeneity in MBS values, more adverse selection, and lower TBA liquidity. Lastly, we provide empirical evidence consistent with model predictions on how MBS pooling changes with trading costs and underlying loan value dispersion and how pooling practices affect MBS heterogeneity and TBA market adverse selection.

Keywords: Agency Mortgage-Backed Securities; Liquidity; Securitization; TBA Trades (search for similar items in EconPapers)
JEL-codes: G10 G21 (search for similar items in EconPapers)
Pages: 68 p.
Date: 2021-05-06
New Economics Papers: this item is included in nep-ban and nep-ure
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2021-31

DOI: 10.17016/FEDS.2021.031

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