Do the Federal Reserve’s Asset Purchases Harm MBS Market ... · Harm MBS Market Liquidity?...

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Pengjie Gao±, Paul Schultz±, and Zhaogang Song*

± University of Notre Dame

* Federal Reserve Board

Annual Central Bank Workshop on Microstructure of Financial Markets, Rome

October , 2014

Do the Federal Reserve’s Asset Purchases Harm MBS Market Liquidity?

Disclaimer: The analysis and conclusions set forth are those of the authors and do not indicate concurrence by the Board of Governors of the Federal Reserve System.

Preliminary and Comments Welcome

QE: Fed’s MBS Purchase in Oct-2011 to Apr-2013

Source: Table 1 2

“One possible cost of conducting additional LSAPs is that these operations could impair the functioning of securities markets. Conceivably, if the Federal Reserve became too dominant a buyer in certain segments of these markets, trading among private agents could dry up, degrading liquidity and price discovery.” (italics added)

- Ben Bernanke Jackson Hole Meetings

August 31, 2012

What we do in this paper 1. Quantify the impact of Fed’s purchases on MBS

liquidity Harm: reduced tradable supply for private investors Improve: Reduce search frictions (Duffie, Garleanu, and Pedersen 05; Vayanos

and Weill 08…) Reduce adverse selection concerns (Pasquariello, Roush, and Vega

14) The impact is an open question The impact is not clear even more in To-be-announced and Specified pool venues

What we do in this paper 2. We empirically investigate channels of the Fed’s

purchase impact on over-the-counter MBS liquidity

Information asymmetry Inventory Search frictions

Such results will shed light on fundamental theories of over-the-counter markets

A Quick Overview of Results Liquidity improvement in both TBA and SP markets TBA segment with Fed purchases: the average trading cost

declines by 0.86 - 0.91 bpts from the non- intervention levels of 1.26 - 1.35 bpts

Corresponding SP segment: the average trading cost decreases by 9.6 - 11.1 bpts from the non-intervention levels of 19.5 - 29.4 bpts

Channels of liquidity improvement TBA segment with Fed purchases: a reduction in both

search frictions and information asymmetry concerns Corresponding SP segment: low costs for inventory

hedging but not reduction in search frictions 6

Literature Impact of unconventional monetary policies on prices Krishnamurthy and Vissing-Jorgensen (2011, 2013) Hancock and Passmore (2011, 2013): MBS yields D’Amico and King (2013): Treasury yields

Microstructure of MBS market Trading cost: Atanasov and Merrick (2013), Bessembinder,

Maxwell and Venkataraman (2013), Friewald, Jankowitsch, and Subrahmanyam (2013), Vickery and Wright (2013)

Network structure: Hollifield, Neklyudov, and Spatt (2013)

Outline

Agency MBS Market and the Fed’s purchases

Data and Empirical Method

Results

Conclusion

Agency MBS Agency Mortgage Backed Securities (MBS)

Residential mortgage & pass-through security Prepayment risk (Default risk taken by Fannie, Freddie,

and Ginnie) Key parameters for TBA: agency, loan term (15y and 30y),

coupon rate More defining parameters: weighted-average maturity,

loan-to-value ratio, credit score, past prepayment rates, occupancy type, geographic composition, etc

Market Structure: two parallel venues To-be-announced (TBA) forward trading Pooling trade: forward contract by agency, loan term, coupon,

price, par amount, settlement date A buyer knows what specific MBS to be delivered only 48-hour

before the settlement date; cheapest-to-deliver Highly liquid: 90% of volume; a cost of 1.2–1.4 bps (our estimate)

Specified pool (SP) trading Buyers know what MBS to get upon transaction: more info TBA ineligible and eligible (better parameters) Less liquid: 10% of volume; a cost of 20–30 bps (our estimate)

Liquidity externality TBA prices serve as a benchmark SP: Atanasov and Merrick (2012) TBAs as hedging tools for SP: Gao, Schultz, and Song (2014)

The Fed’s MBS Purchases Only “Production-coupon” TBAs: coupon rates close to the concurrent primary mortgage rates

(minus a servicing fee) The largest new issuances

We shall study liquidity of “Production coupon” TBAs “Production coupon” SPs “Non-Production coupon” TBAs and SPs

Data Market surveillance data compiled by FINRA From May 16, 2011 & for structured products Data releases by FINRA Similar to non-public version of TRACE corporate bond data

MBS purchases at the CUSIP level from FRBNY eMBS database: TBA and SP CUSIP-level security

characteristics Sample period Pre-LSAPs period (May-2011 to Sep-2011): “Reinvestment Program” (Oct-2011 to Jun-2012): $30 billion QE3 (Jul-2012 to Apr-2013) Period: additional $40 billion

Empirical Method (TBA) Panel regression: both D-C and C-C trades

𝐿𝐿𝐿𝐿𝐿𝐿𝑖𝑖𝑖𝑖 = 𝛼𝛼 + 𝛽𝛽 × Interventionit + �𝛾𝛾𝑗𝑗𝐹𝐹𝐸𝐸𝑖𝑖,𝑗𝑗𝑗𝑗

+ �𝛿𝛿𝑗𝑗𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑙𝑙𝑗𝑗,𝑖𝑖𝑗𝑗

+ 𝜖𝜖𝑖𝑖𝑖𝑖

i: Agency X Maturity X Coupon; FNMA 30-year 4% The main variable of interest is 𝛽𝛽 𝐿𝐿𝐿𝐿𝐿𝐿𝑖𝑖𝑖𝑖: price dispersion, markup

Empirical Method (TBA & SP): Baseline Panel regression ∆𝑃𝑃𝑖𝑖𝑖𝑖 = 𝛼𝛼 + 𝛽𝛽0∆𝑄𝑄𝑖𝑖𝑖𝑖 + 𝛽𝛽1∆𝑄𝑄𝑖𝑖𝑖𝑖 × Interventionit + 𝛽𝛽2Interventionit

+ �𝛾𝛾𝑗𝑗𝐹𝐹𝐸𝐸𝑖𝑖,𝑗𝑗𝑗𝑗

∆𝑃𝑃𝑖𝑖𝑖𝑖: percentage price change from a previous to current trade ∆𝑄𝑄𝑖𝑖𝑖𝑖 = 𝑄𝑄𝑖𝑖𝑖𝑖 − 𝑄𝑄𝑖𝑖𝑖𝑖−𝜏𝜏,𝑄𝑄𝑖𝑖𝑖𝑖 = 1 customer buy, 𝑄𝑄𝑖𝑖𝑖𝑖 = −1 customer sell 𝛽𝛽0: average round-trip transaction cost prior to the Fed purchase Schultz (2001), Bessembinder, Maxwell, and Venkataraman

(2006, 2013) 𝛽𝛽1: the impact of Fed intervention on transaction costs

Key identification: controls Staggered intervention Securities that are eventually “treated,” yet currently

“untreated” serve as “controls” for securities that are currently “treated”

We further fine tune the “control” sample A MBS must be in active issuance to be included as “control” This is to ensure we do not simply pick up liquidity difference

between “production” vs. “non-production” rates MBS

Illustration of Controls

Source: Table 1 16

Result: Liquidity Impact in Production-coupon TBAs (1)

Source: Table 5 17

Result: Liquidity Impact in Production-coupon TBAs (2)

Source: Table 6 18

Liquidity impact: Production-coupon SP (1)

Channels of Liquidity Improvement

“Production-coupon” TBAs Search friction Information asymmetry concerns

“Production-coupon” SP Reduction of dealer’s inventory hedging costs in SP

“Production-coupon” TBAs: adverse selection Comparison of prices of Fed purchases versus purchases just before or after. Large trades are $250 million or more

The Fed’s LSAPs transaction prices exhibit strong mean-reversion.

The Fed’s LSAPs vs. Non-Fed Trades

No evidence that the Fed’s LSAPs provide benchmark prices!

“Production-coupon” TBAs: search

• Large trade imbalance (in trade numbers as well as in dollar amount) indicates stronger search frictions.

• Trade imbalance decreases after the Fed’s LSAPs – which indicates reduction of search frictions.

“Production-coupon” SP: inventory No reduction in search frictions Inventory hedging

Summary The huge Fed purchase of MBS is a fertile ground for

understanding the microstructure of OTC MBS market Liquidity improvement directly and indirectly Channels of liquidity improvement

Implication Policy: the QE programs improve market liquidity rather

than harm it; Terminating the purchases will decrease the market liquidity

OTC structure and trading: importance of search frictions, information asymmetry, and inventory controls when a large player is present

Empirical Model: non-production coupon MBS The Fed did not purchase any non-production rate MBS How to evaluate the LSAPs impact on non-production rate MBS

liquidity? Without a better alternative, we estimate the following models

∆𝑃𝑃𝑖𝑖𝑖𝑖 = 𝛼𝛼 + 𝛽𝛽0∆𝑄𝑄𝑖𝑖𝑖𝑖 + 𝛽𝛽1∆𝑄𝑄𝑖𝑖𝑖𝑖 × Revt + 𝛽𝛽2 × ∆𝑄𝑄𝑖𝑖𝑖𝑖 × QE3t + �𝛾𝛾𝑗𝑗𝐹𝐹𝐸𝐸𝑖𝑖,𝑗𝑗𝑗𝑗

𝐿𝐿𝐿𝐿𝐿𝐿𝑖𝑖𝑖𝑖 = 𝛼𝛼 + 𝛽𝛽1 × Revt +β2 × QE3t +�𝛾𝛾𝑗𝑗𝐹𝐹𝐸𝐸𝑖𝑖,𝑗𝑗𝑗𝑗

where Revt and QE3t are two time dummy variables denoting

MEP and QE3 periods

Liquidity for Non-Production coupon TBAs (1)

Source: Table 7 29

Liquidity for Non-Production coupon TBAs (2)

Liquidity in Non-Production coupon SP (1)

Do the Federal Reserve’s Asset Purchases Harm MBS Market ... · Harm MBS Market Liquidity?...

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