The Federal Reserve Bank of New York works to promote sound and well-functioning financial systems and markets through its provision of industry and payment services, advancement of infrastructure reform in key markets and training and educational support to international institutions.
The Outreach & Education function engages, empowers and educates the public in the Second District. Our outreach mission furthers the Bank’s commitment to the region by listening to the communities we serve and developing programs, analysis and sponsored conferences and clinics to help meet their needs. Our education mission aims to advance public knowledge about the Federal Reserve System and its role in the economy.
Most mortgages in the United States are securitized in agency mortgage-backed securities (MBS), and thus the yield spreads on these securities are a key determinant of homeowners’ funding costs. We study the variation in these spreads, over time and across securities, and document that they display a cross-sectional smile pattern with respect to the securities’ coupon rates. We propose non-interest-rate prepayment risk as a candidate driver of the spread variation and present a new pricing model that uses “stripped” MBS prices to identify the contribution of this risk. The pricing model finds the smile to be explained by prepayment risk, while the time-series variation is mostly accounted for by a non-prepayment risk factor that co-moves with MBS supply and credit risk in other fixed-income markets. We then study the MBS market’s response to the Fed’s large-scale asset purchases and use the pricing model to interpret the post-announcement divergence of spreads across MBS.