Parameter Stability and the Valuation of Mortgages and Mortgage-Backed Securities
Real Estate Economics, March 2012
Posted: 19 Apr 2011
Date Written: April 18, 2011
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
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