Parameter Stability and the Valuation of Mortgages and Mortgage-Backed Securities
California State University at Fullerton
Yun W. Park
Korea Securities Research Institute (KSRI)
Richard K. Green
University of Southern California - Lusk Center for Real Estate
April 18, 2011
Real Estate Economics, March 2012
The recent financial crisis was triggered by large and unexpected losses on mortgages and mortgage-related securities. Here we examine model risk arising from innovations in mortgage markets and how those innovations affect asset values. In particular, we examine the effect of parameter instability in the prepayment function. Using carefully constructed micro-data, we find that the refinancing propensity was greater in 1998 for a 1997 issue given the same incentives, compared to the 1993 performance of a 1992 issue. The associated change in cash flow patterns produces economically significant changes in asset prices. Results are robust to alternative term structure models.
Keywords: mortgage, model risk, prepayment
Date posted: April 19, 2011
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