Funding Liquidity and the Valuation of Mortgage-Backed Securities

We study the relationship between funding liquidity and the valuation of mortgage-backed securities. Most of the financing for mortgage-backed securities occurs through a trade known as a dollar roll, the simultaneous sale and purchase of forward contracts on mortgage-backed securities that is analogous to a repurchase agreement. We develop a four-factor no-arbitrage model for valuing mortgage-backed securities that allows for the valuation of dollar rolls. Unlike previous models of the dollar roll, we allow for the possibility of a prepayment risk premium. We develop a new model-implied measure of funding liquidity of MBS investors that is independent of prepayment risk premia and agency credit spreads. We find that our implied funding liquidity spread is strongly related to measures of intermediary balance sheet constraints and primary dealer positions in mortgage-backed securities.