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Finance and Economics Discussion Series logo links to FEDS home page An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?
Chris Downing, Richard Stanton, and Nancy Wallace

Abstract: Mortgage-backed securities, with their relative structural simplicity and their lack of recovery rate uncertainty if default occurs, are particularly suitable for developing and testing risky debt valuation models. In this paper, we develop a two-factor structural mortgage pricing model in which rational mortgage-holders endogenously choose when to prepay and default subject to i. explicit frictions (transaction costs) payable when terminating their mortgages, ii. exogenous background terminations, and iii. a credit-related impact of the loan-to-value ratio (LTV) on prepayment. We estimate the model using pool-level mortgage termination data for Freddie Mac Participation Certificates, and find that the effect of the house price factor on the results is both statistically and economically significant. Out-of-sample estimates of MBS prices produce option adjusted spreads of between 5 and 25 basis points, well within quoted values for these securities.

Keywords: Prepayment, default, mortgage, valuation, house price, transaction cost, heterogeneity

Full paper (302 KB PDF)

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Last update: August 15, 2003