Liquidity in a Market for Unique Assets: Specified Pool and To‐Be‐Announced Trading in the Mortgage‐Backed Securities Market

• DOI: http://doi.org/10.1111/jofi.12496
• Author: PENGJIE GAO,ZHAOGANG SONG,PAUL SCHULTZ
• Published date: 01 June 2017
• Date: 01 June 2017

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 3 •JUNE 2017

Liquidity in a Market for Unique Assets:

Specified Pool and To-Be-Announced Trading

in the Mortgage-Backed Securities Market

PENGJIE GAO, PAUL SCHULTZ, and ZHAOGANG SONG∗

ABSTRACT

Agency mortgage-backed securities (MBS) trade simultaneously in a market for spec-

ified pools (SPs) and in the to-be-announced (TBA) forward market. TBA trading

creates liquidity by allowing thousands of different MBS to be traded in a handful of

TBA contracts. SPs that are eligible to be traded as TBAs have significantly lower

trading costs than other SPs. We present evidence that TBA eligibility, in addition to

characteristics of TBA-eligible SPs, lowers trading costs. We show that dealers hedge

SP inventory with TBA trades, and they are more likely to prearrange trades in SPs

that are difficult to hedge.

THE MARKET FOR AGENCY MORTGAGE-BACKED securities (MBS) is among the

largest, most active, and most liquid of all securities markets. At first glance,

the market’s liquidity is surprising because each MBS is unique and is com-

posed of specific mortgages with their own prepayment characteristics. In

this paper, we study the institutional feature of this market that allows it

to work so well, namely, parallel trading in a to-be-announced (TBA) forward

market in MBS and a specified pool (SP) market in which specific MBS are

traded.

TBA trading makes the agency MBS market liquid in three ways. First,

the TBA market takes thin markets for thousands of different MBS with

different prepayment characteristics and trades them through a handful of

thickly traded cheapest-to-deliver contracts. In this way, liquidity is increased

for the MBS that are traded there instead of as SPs. Second, eligibility for TBA

∗Pengjie Gao and Paul Schultz are with the Mendoza College of Business, University of Notre

Dame. Zhaogang Song is with Johns Hopkins University. This paper was written while Zhaogang

Song was at the Board of Governors of the Federal Reserve. We thank the Editor (Bruno Biais) and

referees for suggestions that significantly improved this paper. We thank Shane Corwin, Martijn

Cremers, Bill Maxwell, Kumar Venkataraman, and seminar participants at the University of

Nebraska, the University of Notre Dame, SMU, and the Vienna Graduate School of Finance for

helpful comments. In addition, we would like to thank John Kandrac, Bernd Schlusche, and Renee

Schultz for their help on MBS characteristics. Finally, we are grateful to Alie Diagne and Ola

Persson of FINRA and Christine Black from the Board of Governors of the Federal Reserve, who

helped with data clearance. FINRA screened the paper to ensure that confidential dealer identities

were not revealed. The authors read the Journal of Finance’s disclosure policy and have no conflicts

of interest to disclose.

DOI: 10.1111/jofi.12496

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trading makes SPs more liquid by giving dealers an option to lay off SP in-

ventory through the more liquid TBA market. Third, parallel TBA trading

increases liquidity for SP trades. There are several possible reasons why TBA

trading may increase SP liquidity and we provide evidence for one: dealers use

TBA trades to hedge SP positions.

We are not the first to show that TBA trading is cheaper than SP trading.

Bessembinder, Maxwell, and Venkataraman (2013) examine trading costs for

structured credit products that include but are not limited to MBS. They ob-

serve that TBA trades are much cheaper than other MBS trades. Friewald,

Jankowitsch, and Subrahmanyam (2014) study the tradeoff between accuracy

in measuring liquidity and the disclosure of information to market partici-

pants. As part of their study, they find that trading costs are much lower for

TBA trades than SP trades. Atanasov and Merrick (2012) examine the integra-

tion of TBA and SP markets, and show that for large trades the two markets

are well integrated. Like the others, they find that SP trading costs are much

higher than TBA costs.

Unlike these previous studies, our paper distinguishes between SPs that

are eligible to be traded in the TBA market and those that are ineligible to

be traded there. We show that TBA-eligible SPs are much cheaper to trade

than TBA-ineligible SPs. TBA eligibility itself can increase liquidity by giving

dealers and potential buyers of an SP an option to deliver the SP in a TBA

trade if market conditions change. We provide evidence, in two separate tests,

that TBA eligibility itself increases liquidity. In the first, we use loan-to-value

(LTV) levels and a dummy variable for LTVs greater than 1.05 to see whether

there is an abrupt change in trading costs at the LTV cutoff for TBA eligibility.

We find that trading costs in general decline with LTV ratios, but increase

sharply at the 1.05 cutoff. Our second test is a variation on propensity score

matching. In the first stage we estimate the probability that an SP is TBA

eligible using characteristics that include minimum and maximum loan values,

LTV ratios, and average Fair Isaac Company (henceforth FICO) scores. In the

second stage, we group SPs by the estimated probability that the SP is TBA

eligible and test whether actual eligibility affects trading costs. After adjusting

for the probability that an SP is TBA eligible, we find that TBA eligibility itself

significantly decreases trading costs.

We also provide the first evidence that parallel TBA trading makes the SP

market more liquid. We identify an exogenous factor that directly affects TBA

trading but not SP trading: TBA settlement dates. There is one settlement date

each month for all TBA trades of MBS with a given maturity and issuer. These

dates are set by the Securities Industry and Financial Markets Association

(SIFMA) well in advance of the settlement month. Traders who do not wish

to take or deliver MBS roll over their positions before the settlement date,

resulting in TBA trading volume that is three to four times as large in the days

prior to settlement dates as it is during the rest of the month. SP trades can

be settled at any time during the month. Nevertheless, trading costs for SPs,

like TBA trading costs, are much lower prior to TBA settlement dates when

the predictable volume of TBA trading is high.

Liquidity in a Market for Unique Assets 1121

There are several plausible explanations for why parallel TBA trading re-

duces SP trading costs. Our data allow us to explore one of them. This paper

is the first to show that dealers typically hedge SP inventory changes with

offsetting TBA trades. For individual dealers we regress daily changes in TBA

inventory on changes in the inventory of TBA-eligible SPs and TBA-ineligible

SPs with the same maturity and coupon. The coefficients are negative, im-

plying that the median dealer hedges SP inventories with TBA trades. The

coefficients on changes in inventory of SPs that are not TBA eligible are closer

to zero than the coefficients on TBA-eligible inventory changes, suggesting that

SPs that are not TBA eligible are less likely to be hedged, all else equal. This

is not surprising. TBA-ineligible SPs have different characteristics from TBA-

eligible ones, and we find that TBA trades are not as effective at hedging price

changes for TBA-ineligible SPs as they are at hedging changes in TBA-eligible

SP prices.

Difficulty in hedging can reduce liquidity. We present evidence that dealers

are reluctant to take hard-to-hedge SPs into inventory. They are more likely

to prearrange a sale of the SP to a second customer before purchasing the

SP from the first customer. This means that investors have to wait to sell

unwanted MBS while the dealer searches for a buyer. This is a cost that we

cannot measure.

Regulators have recently expressed concern about the liquidity of over-the-

counter markets for corporate and municipal bonds and have suggested that

more transparency is needed. Our findings suggest another way to increase

liquidity. Forward market trading of MBS in the TBA market appears to lower

trading costs both for those MBS traded in the TBA market and for the MBS

traded in the parallel SP market. Some legal obstacles would need to be over-

come, but it may make sense to have similar forward markets in municipal

and corporate bonds. Bonds included in such a forward market would need

to be sufficiently homogeneous with respect to default risk and other charac-

teristics. But there may be, for example, enough relatively homogeneous, 5%

20-year, AA-rated industrial bonds to create a liquid cheapest-to-deliver for-

ward market.1The existence of a liquid forward market would be likely to

create incentives for issuers to issue standardized bonds that could be traded

in the forward market.

The rest of the paper is organized as follows. Section Idiscusses how the

secondary market for MBS operates. Section II describes the data used here.

Section III provides estimates of trading costs in the TBA and SP markets. In

Section IV we examine the impact of TBA eligibility on SP liquidity. Section V

presents evidence that eligibility for TBA trading lowers SP trading costs. In

Section VI, we show that dealers use the TBA market to hedge SP positions.

Section VII concludes.

1Spatt (2004) makes the same point. He observes that many corporate and municipal bonds

are close substitutes, but that these bonds, unlike MBS, “are not traded interchangeably in the

marketplace.”