What Constitutes a Good Model? An Analysis of Models for Mortgage Backed Securities

Abstract

The U.S. agency mortgage backed securities (MBS) market is deep and highly liquid, yet modeling MBS is extremely challenging. This paper applies market participants' desired requirements for a good pricing model to MBS pricing models provided by six of the top MBS dealers. We find that five out of the six models fall short of the desired requirements. The five models are highly correlated, but less correlated with the best model, indicating potential herding among MBS analysts. The most undesirable property of the failed models is the high correlation with the underlying interest rate and options markets.

Keywords: Mortgage-backed securities, option-adjusted spreads, market efficiency

JEL Classification: G10, G13, G14