Keywords: Prepayment, default, mortgage, valuation, house price, transaction cost, heterogeneity
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.
Full paper (302 KB PDF)
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Last update: August 15, 2003