Dealers and the Dealer of Last Resort: Evidence from the Agency MBS Market in the COVID-19 Crisis

Abstract

Since COVID-19 market disruptions started in early March 2020, dealers maintained the usual liquidity provision in the agency MBS market by taking cash inventory and hedging inventory risk with forward contracts. However, dealers did not increase the amount of liquidity provision until the Fed established the Primary Dealer Funding Facility (PDCF). The cash and forward prices significantly diverged, even when the Fed established the PDCF and when it began standard purchase operations that settle on a monthly cycle; in contrast, they converged after the Fed deployed nonstandard purchase operations to take MBS from dealers promptly. These findings imply that dealers' funding constraints played some role, but balance sheet constraints played the major role. Further analyses across dealers and markets point to regulation and fragmentation as important drivers of dealers' balance sheets. Customers' selling increased when price divergence reverted, inconsistent with a reduction in their liquidity needs that is conjectured by some existing studies.

Keywords: arbitrage, cash, dealer, liquidity, MBS, specified pool, TBA

JEL Classification: D8, G2