An Analysis of the Ex-Ante Probabilities of Mortgage Prepayment and Default

Posted: 24 Oct 1998

See all articles by Tyler T. Yang

Tyler T. Yang

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management

Henry Buist

Fannie Mae

Isaac F. Megbolugbe

Federal National Mortgage Association (Fannie Mae) - Office of Housing Research

Abstract

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 presence of income allows considering consumption-theoretic determinants of termination. The role of mortgage underwriting rules in restricting optimal prepayment is also explicitly modeled. Numerical ex-ante prepayment and default rates based on the theoretical model come much closer to historical experience.

Suggested Citation

Yang, Tyler T. and Buist, Henry and Megbolugbe, Isaac F., An Analysis of the Ex-Ante Probabilities of Mortgage Prepayment and Default. Real Estate Economics, Vol. 26, No. 4, 1998. Available at SSRN: https://ssrn.com/abstract=124068

Tyler T. Yang (Contact Author)

Federal Home Loan Mortgage Corporation (FHLMC) - Portfolio Management ( email )

McLean, VA 22101
United States

Henry Buist

Fannie Mae ( email )

3900 Wisconsin Avenue
Washington, DC 20016
United States
202-752-3483 (Phone)

Isaac F. Megbolugbe

Federal National Mortgage Association (Fannie Mae) - Office of Housing Research ( email )

4000 Wisconsin Ave. NW
Washington, DC 20016
United States
202-274-5065 (Phone)
202-274-8111 (Fax)

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