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

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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.

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  • Yesol Huh & You Suk Kim, 2021. "Cheapest-to-Deliver Pricing, Optimal MBS Securitization, and Market Quality," Finance and Economics Discussion Series 2021-031, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2021-31
    DOI: 10.17016/FEDS.2021.031
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    Cited by:

    1. Jin-Wook Chang & Matt Darst, 2022. "Moldy Lemons and Market Shutdowns," Finance and Economics Discussion Series 2022-013, Board of Governors of the Federal Reserve System (U.S.).

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    More about this item

    Keywords

    Agency Mortgage-Backed Securities; Liquidity; Securitization; TBA Trades;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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