Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities

Posted: 18 Apr 2016

See all articles by Mikhail Chernov

Mikhail Chernov

UCLA Anderson

Brett Dunn

University of California, Los Angeles (UCLA)

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2016

Abstract

We introduce a reduced-form modeling framework for mortgage- backed securities in which we solve for the implied prepayment function from the cross section of market prices. From the implied prepayment function, we find that prepayment rates are driven not only by interest rates, but also by two macroeconomic factors: turnover and rate response. Intuitively, turnover represents prepayments for exogenous reasons like employment-related moves, household income shocks, and foreclosures, while rate response reflects frictions faced by borrowers in refinancing into a lower rate. We find that the implied turnover and rate response measures are in fact significantly related to macroeconomic measures such as consumption growth, the unemployment rate, housing values, credit availability, and market uncertainty. Implied prepayments are substantially higher than actual prepayments, providing direct evidence of significant prepayment risk premia in mortgage-backed security prices. We analyze the properties of the prepayment risk premium and find that it is almost entirely due to compensation for turnover risk. We also find evidence that mortgage- backed security prices were significantly affected by Fannie Mae credit risk and the Federal Reserve’s Quantitative Easing Programs.

Keywords: Affine models, mortgage-backed securities, prepayment function

JEL Classification: G12, G13

Suggested Citation

Chernov, Mikhail and Dunn, Brett and Longstaff, Francis A., Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities (March 2016). CEPR Discussion Paper No. DP10947, Available at SSRN: https://ssrn.com/abstract=2766574

Mikhail Chernov (Contact Author)

UCLA Anderson ( email )

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Brett Dunn

University of California, Los Angeles (UCLA) ( email )

405 Hilgard Avenue
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Los Angeles, CA 90095
United States

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2218 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

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