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Understanding Mortgage Spreads

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  • Nina Boyarchenko
  • Andreas Fuster
  • David O Lucca

Abstract

Because most mortgages in the United States are securitized in agency mortgage-backed securities (MBS), yield spreads on MBS are a key determinant of homeowners’ funding costs. We study variation in MBS spreads in the time series and across securities and document that MBS spreads show a pronounced cross-sectional smile with respect to the securities’ coupon rates. We present a new pricing model that uses “stripped” MBS prices to identify the contribution of non-interest-rate prepayment risk to spreads and find that this risk explains the smile, whereas the time-series spread variation is mostly accounted for by nonprepayment risk factors.Received March 30, 2015; editorial decision November 21, 2018 by Editor Leonid Kogan. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Suggested Citation

  • Nina Boyarchenko & Andreas Fuster & David O Lucca, 2019. "Understanding Mortgage Spreads," Review of Financial Studies, Society for Financial Studies, vol. 32(10), pages 3799-3850.
    • Handle: RePEc:oup:rfinst:v:32:y:2019:i:10:p:3799-3850.
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    Cited by:

    1. Mikhail Chernov & Brett R. Dunn & Francis A. Longstaff, 2018. "Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities," Review of Financial Studies, Society for Financial Studies, vol. 31(3), pages 1132-1183.
    2. Andreas Fuster & Stephanie Lo & Paul S. Willen, 2017. "The time-varying price of financial intermediation in the mortgage market," Working Papers 16-28, Federal Reserve Bank of Boston.
    3. Ospina, Juan & Uhlig, Harald, 2018. "Mortgage-Backed Securities and the Financial Crisis of 2008: a Post Mortem," CEPR Discussion Papers 12852, C.E.P.R. Discussion Papers.
    4. Beltratti, Andrea & Benetton, Matteo & Gavazza, Alessandro, 2017. "The role of prepayment penalties in mortgage loans," Journal of Banking & Finance, Elsevier, vol. 82(C), pages 165-179.
    5. Andreas Fuster & Aurel Hizmo & Lauren Lambie-Hanson & James Vickery & Paul S. Willen, 2021. "How Resilient Is Mortgage Credit Supply? Evidence from the COVID-19 Pandemic," NBER Working Papers 28843, National Bureau of Economic Research, Inc.
    6. Haoyang Liu & Zhaogang Song & James Vickery, 2021. "Defragmenting Markets: Evidence from Agency MBS," Staff Reports 965, Federal Reserve Bank of New York.
    7. Andreas Fuster & Paul Goldsmith‐Pinkham & Tarun Ramadorai & Ansgar Walther, 2022. "Predictably Unequal? The Effects of Machine Learning on Credit Markets," Journal of Finance, American Finance Association, vol. 77(1), pages 5-47, February.
    8. Andrea L. Eisfeldt & Hanno Lustig & Lei Zhang, 2017. "Complex Asset Markets," NBER Working Papers 23476, National Bureau of Economic Research, Inc.
    9. Fuster, Andreas & Lucca, David O & Vickery, James, 2022. "Mortgage-Backed Securities," CEPR Discussion Papers 16989, C.E.P.R. Discussion Papers.
    10. Yuriy Kitsul & Marcelo Ochoa, 2016. "Funding Liquidity Risk and the Cross-section of MBS Returns," Finance and Economics Discussion Series 2016-052, Board of Governors of the Federal Reserve System (U.S.).
    11. David Lucca & Jonathan H. Wright, 2022. "The Narrow Channel of Quantitative Easing: Evidence from YCC Down Under," NBER Working Papers 29971, National Bureau of Economic Research, Inc.
    12. Zhiguo He & Arvind Krishnamurthy, 2018. "Intermediary Asset Pricing and the Financial Crisis," Annual Review of Financial Economics, Annual Reviews, vol. 10(1), pages 173-197, November.
    13. Christopoulos, Andreas D. & Jarrow, Robert A., 2018. "CMBS market efficiency: The crisis and the recovery," Journal of Financial Stability, Elsevier, vol. 36(C), pages 159-186.
    14. Nicola Fusari & Wei Li & Haoyang Liu & Zhaogang Song, 2020. "Asset Pricing with Cohort-Based Trading in MBS Markets," Staff Reports 931, Federal Reserve Bank of New York.
    15. Aytek Malkhozov & Philippe Mueller & Andrea Vedolin & Gyuri Venter, 2016. "Mortgage Risk and the Yield Curve," Review of Financial Studies, Society for Financial Studies, vol. 29(5), pages 1220-1253.
    16. Peter Diep & Andrea L. Eisfeldt & Scott Richardson, 2016. "Prepayment Risk and Expected MBS Returns," NBER Working Papers 22851, National Bureau of Economic Research, Inc.
    17. Kim, Jong-Min & Kim, Dong H. & Jung, Hojin, 2020. "Modeling non-normal corporate bond yield spreads by copula," The North American Journal of Economics and Finance, Elsevier, vol. 53(C).
    18. Thiago Revil T. Ferreira & Samer Shousha, 2020. "Scarcity of Safe Assets and Global Neutral Interest Rates," International Finance Discussion Papers 1293, Board of Governors of the Federal Reserve System (U.S.).
    19. Jiakai Chen & Haoyang Liu & Asani Sarkar & Zhaogang Song, 2020. "Dealers and the Dealer of Last Resort: Evidence from MBS Markets in the COVID-19 Crisis," Staff Reports 933, Federal Reserve Bank of New York.
    20. Thiago Revil T. Ferreira & Samer Shousha, 2021. "Supply of Sovereign Safe Assets and Global Interest Rates," International Finance Discussion Papers 1315, Board of Governors of the Federal Reserve System (U.S.).

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    More about this item

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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