Funding Liquidity and the Valuation of Mortgage-Backed Securities

Abstract

We study the relationship between funding liquidity and the valuation of mortgage-backed securities. Most of the financing for mortgage-backed securities occurs through a trade known as a dollar roll, the simultaneous sale and purchase of forward contracts on mortgage-backed securities that is analogous to a repurchase agreement. We develop a four-factor no-arbitrage model for valuing mortgage-backed securities that allows for the valuation of dollar rolls. Unlike previous models of the dollar roll, we allow for the possibility of a prepayment risk premium. We develop a new measure of mortgage specialness that is independent of prepayment risk premia and agency credit spreads. We find that specialness is related to measures of balance sheet constraints and primary dealer positions in mortgage-backed securities.

Keywords: Mortgage-backed securities, funding liquidity, affine models, prepayment function, TBA contracts, dollar rolls

JEL Classification: G12, G13, G21