An Analysis of Ex-Ante Probabilities of Mortgage Prepayment and Default
Tyler T. Yang
Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management
Isaac F. Megbolugbe
Federal National Mortgage Association (Fannie Mae) - Office of Housing Research
Observed mortgage prepayment and default rates have been far different than the ruthless option exercise rates predicted by contingent claims models of mortgage pricing. The discrepancies have been attributed to both the competing risk nature of prepayment and default and to transactions costs. This paper tries a different means of reconciliation. We introduce a third stochastic process, household income, to the usual pricing model that includes only the spot interest rate and the house price. The role of mortgage underwriting constraints in governing mortgage behavior is also modeled. Numerical results show that the theoretical ex-ante prepayment and default rates in the more general model come much closer to historical experience.
JEL Classification: G21working papers series
Date posted: April 24, 1998
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