Funding Liquidity and the Valuation of Mortgage-Backed Securities

Abstract

We study the relation between funding liquidity and the valuation of mortgage-backed securities. Most MBS positions are financed through a trade known as a dollar roll, the simultaneous sale and purchase of MBS forward contracts. We develop a four-factor no-arbitrage MBS valuation model that allows us to value dollar roll trades based on exposure to (i) interest rates; (ii) prepayments; (iii) credit risk; and (iv) funding liquidity. We improve upon previous studies of MBS funding costs by incorporating maturity-dependent prepayment behavior and distinguishing between prepayment and interest rate risk. The model tightly fits the cross- section and term structure of MBS forward contracts, with a median RMSE of 15.9 cents per $100 notional, a 40|-.2.-| reduction over the prior literature. Our implied funding liquidity spread is strongly related to proxies for intermediary balance sheet costs and primary dealer MBS positions. We find that agency MBS is a segmented market whose financing costs are distinct from those in other large fixed income markets.

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

JEL Classification: G12, G13, G21