Academic journal article Real Estate Economics

An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?

Academic journal article Real Estate Economics

An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?

Article excerpt

This article develops a two-factor structural mortgage pricing model in which rational mortgage-holders choose when to prepay and default in response to changes in both interest rates and house prices. We estimate the model using comprehensive data on the pool-level termination rates for Freddie Mac Participation Certificates issued between 1991 and 2002. The model exhibits a statistically and economically significant improvement over the nested one-factor (interest-rate only) model in its ability to match historical prepayment data. Moreover, the two-factor model produces origination prices that are significantly closer to those quoted in the to-be-announced market than the one-factor model. Our results have important implications for hedging mortgage-backed securities.

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The residential mortgage-backed security (MBS) market is one of the largest and fastest-growing bond markets in the United States. (1) Valuing and hedging MBS requires a model for both the prepayment and default behavior of the underlying mortgages. While our understanding of this behavior has improved dramatically over the last two decades, significant challenges still remain. These challenges include, for example, the persistence of model-based MBS pricing errors (quantified in terms of the option-adjusted spread, or OAS), and the need for improved hedging strategies demonstrated by the sizable losses on MBS positions incurred by Askin Capital Management in the early 1990s and by Fannie Mae's recent problems with a large negative duration gap in its portfolio. (2) Further, for firms that participate in the MBS market, recent changes in accounting standards now require firms to account for hedging effectiveness directly on the income statement, raising the visibility of any hedging mistakes. (3)

Some of these problems stem, at least in part, from the widespread use of models for pricing and hedging MBS that focus principally on the effect of interest rates on mortgage prepayment. While interest rates are generally acknowledged to be the most important factor affecting prepayment, there is a substantial literature suggesting that house prices also play an important role. For example, Stein (1995), Archer, Ling and McGill (1996), Mayer and Genesove (1997) and Mattey and Wallace (1998, 2001) emphasize the importance of housing prices as a determinant of regional-level household mobility. To the extent that declines in house prices impinge on borrowers' mobility, housing turnover and hence prepayments would fall. In a similar vein, Longstaff (2004) suggests that declining house prices reduce refinancing activity by impairing borrowers' credit quality, thereby hurting their chances to qualify for new loans. Conversely, several studies have shown that gains in home equity have a significant influence on the propensity to refinance, including, among others, Becketti and Morris (1990), Monsen (1992), Caplin, Freeman and Tracy (1993) and Krishnamurthy, Gabaix and Vigneron (2004). According to survey evidence reported in Canner, Dynan and Passmore (2002), 45% of homeowners who refinanced their mortgages in 2001 and early 2002 used the opportunity to extract equity. In summary, if house price movements affect mortgage prepayment in these and other ways, then any MBS pricing model that omits house prices as a state variable is misspecified.

A related issue is that the effects of mortgage defaults on MBS prices have received much less attention from both practitioners and the academic literature (notable exceptions in the literature include Kau et al. (1992, 1995), Schwartz and Torous (1992, 1993), Kau (1995), Deng, Quigley and Van Order (2000)). There are two basic reasons for the focus on prepayment rather than default. First, it is well known that defaults are generally rare events, given that most MBS are backed by first-lien mortgages protected by homeowner equity equal to 20% of the mortgage principal (80% loan-to-value ratio). …

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