Understanding Mortgage Spreads

79 Pages Posted: 29 May 2014 Last revised: 22 Jun 2018

See all articles by Nina Boyarchenko

Nina Boyarchenko

Federal Reserve Bank of New York

Andreas Fuster

Swiss National Bank - Financial Stability

David O. Lucca

Federal Reserve Banks - Federal Reserve Bank of New York

Date Written: April 1, 2017

Abstract

Most mortgages in the U.S. are securitized in agency mortgage-backed securities (MBS). Yield spreads on these securities are thus a key determinant of homeowners’ funding costs. We study variation in MBS spreads over time and across securities, and document a cross-sectional smile pattern in MBS spreads with respect to the securities’ coupon rates. We propose non-interest-rate prepayment risk as a candidate driver of MBS spread variation and present a new pricing model that uses “stripped” MBS prices to identify the contribution of this prepayment risk to the spread. The pricing model finds that the smile can be explained by prepayment risk, while the time-series variation is mostly accounted for by a non-prepayment risk factor that co-moves with MBS supply and credit risk in other fixed income markets. We use the pricing model to study the MBS market response to the Fed’s large-scale asset purchase program and to interpret the post-announcement divergence of spreads across MBS.

Keywords: agency mortgage-backed securities, option-adjusted spreads, prepayment risk, OAS smile

JEL Classification: G10, G12, G13

Suggested Citation

Boyarchenko, Nina and Fuster, Andreas and Lucca, David O., Understanding Mortgage Spreads (April 1, 2017). FRB of New York Staff Report No. 674, Available at SSRN: https://ssrn.com/abstract=2443034 or http://dx.doi.org/10.2139/ssrn.2443034

Nina Boyarchenko

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-7339 (Phone)
212-720-1582 (Fax)

Andreas Fuster

Swiss National Bank - Financial Stability ( email )

Boersenstrasse 15
Zurich, CH-8022
Switzerland

David O. Lucca (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

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