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

Abstract

We study optimal securitization and its impact on market quality in the agency mortgage-backed securities (MBS) market. Many MBS are traded in the liquid to-be-announced (TBA) market, which however induces adverse selection due to cheapest-to-deliver pricing. We find that lenders pool high-value loans separately and trade them in a less liquid market. We estimate a structural model of MBS pooling and trading to study welfare implications of pooling policies. Negative externality of strategic pooling on the TBA market results in lower liquidity and welfare in equilibrium. Limiting strategic pooling keeps overall trading costs low but does not benefit high-value loans.

Keywords: Agency Mortgage-Backed Securities, TBA Trades, Securitization, Liquidity

JEL Classification: G21, G10