TBA Trading and Liquidity in the Agency MBS Market

Abstract

1. INTRODUCTION The U.S. residential mortgage market has experienced significant turmoil recent years, leading to important shifts the way mortgages are funded. Mortgage securitization by private financial institutions declined to negligible levels during the financial crisis that began August 2007, and remains low today. In contrast, throughout the crisis there continued to be significant ongoing securitization the agency mortgage-backed-securities (MBS) market, consisting of MBS with a credit guarantee by Fannie Mae, Freddie Mac, or Ginnie Mae. (1) Agency MBS the amount of $2.89 trillion were issued 2008 and 2009, but no non-agency securitizations of new loans occurred during this period. The outstanding stock of agency MBS also increased significantly during the crisis period, from $3.99 trillion at June 2007 to $5.27 trillion by December 2009. (2) A key distinguishing feature of agency MBS is that each bond either carries an explicit government credit guarantee or is perceived to carry an implicit one, protecting investors from credit losses case of defaults on the underlying mortgages. (3) This government backing has been the subject of a long-running academic and political debate. A second, less widely recognized feature is the existence of a liquid forward market for trading agency MBS, out to a horizon of several months. (4) The liquidity of this market improves market functioning and helps mortgage lenders manage risk, since it allows them to lock in sale prices for new loans as, or even before, those mortgages are originated. More than 90 percent of agency MBS trading volume occurs this forward market, which is known as the TBA (to-be-announced) market. In a TBA trade, the seller of MBS agrees to a sale price, but does not specify which particular securities will be delivered to the buyer on settlement day. Instead, only a few basic characteristics of the securities are agreed upon, such as the coupon rate, the issuer, and the approximate face value of the bonds to be delivered. While the agency MBS market consists of thousands of heterogeneous MBS pools backed by millions of individual mortgages, the TBA trading convention allows trading to be concentrated only a small number of liquid forward contracts. TBA prices, which are observable to market participants, also serve as the basis for pricing and hedging a variety of other MBS, which The main goal of this article is to describe the basic features and mechanics of the TBA market, and to review recent legislative changes that have affected the types of mortgages eligible for TBA trading. The article also presents some preliminary evidence suggesting that the liquidity benefits associated with TBA eligibility increase MBS prices and reduce mortgage interest rates. Our analysis exploits changes legislation to help disentangle the effects of TBA eligibility from other characteristics of agency MBS. In particular, we study pricing for mortgages that became eligible for agency MBS securitization through legislation 2008, but that were ruled ineligible to be delivered to settle TBA trades. We show that MBS backed by super-conforming mortgages trade at a persistent price discount the secondary market, and also that interest rates on such loans are correspondingly higher the primary mortgage market. Preliminary evidence suggests that these stylized facts are not fully explained by differences prepayment risk. We interpret our estimates to suggest that the liquidity benefits of TBA eligibility may be of the order of 10 to 25 basis points on average 2009 and 2010, and are larger during periods of greater market stress. Our institutional discussion and empirical results support the view that the TBA market serves a valuable role the mortgage finance system. This finding suggests that evaluations of proposed reforms to U.S. housing finance should take into account potential effects of those reforms on the operation of the TBA market and its liquidity. …