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

67 Pages Posted: 27 Jul 2020 Last revised: 19 Apr 2021

See all articles by Yesol Huh

Yesol Huh

Board of Governors of the Federal Reserve System

You Suk Kim

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: April 19, 2020

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, TBA Trades, Securitization, Liquidity

JEL Classification: G21, G10

Suggested Citation

Huh, Yesol and Kim, You Suk, Cheapest-to-Deliver Pricing, Optimal MBS Securitization, and Market Quality (April 19, 2020). Available at SSRN: https://ssrn.com/abstract=3640783 or http://dx.doi.org/10.2139/ssrn.3640783

Yesol Huh (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
(202) 973-6943 (Phone)

HOME PAGE: http://sites.google.com/site/yesolhuh

You Suk Kim

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
76
Abstract Views
463
rank
366,836
PlumX Metrics