An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?

40 Pages Posted: 17 Oct 2003

See all articles by Chris Downing

Chris Downing

BlackRock

Richard Stanton

University of California, Berkeley - Haas School of Business

Nancy Wallace

University of California, Berkeley - Real Estate Group

Date Written: April 25, 2003

Abstract

Mortgage-backed securities, with their relative structural simplicity and their lack of recovery rate uncertainty if default occurs, are particularly suitable for developing and testing risky debt valuation models. In this paper, we develop a two-factor structural mortgage pricing model in which rational mortgage-holders endogenously choose when to prepay and default subject to i. explicit frictions (transaction costs) payable when terminating their mortgages, ii. exogenous background terminations, and iii. a credit-related impact of the loan-to-value ratio (LTV) on prepayment. We estimate the model using pool-level mortgage termination data for Freddie Mac Participation Certificates, and find that the effect of the house price factor on the results is both statistically and economically significant. Out-of-sample estimates of MBS prices produce option adjusted spreads of between 5 and 25 basis points, well within quoted values for these securities.

Keywords: Prepayment, default, mortgage, valuation, house price, transaction cost, heterogeneity

JEL Classification: G12, G13, G21

Suggested Citation

Downing, Christopher T. and Stanton, Richard H. and Wallace, Nancy E., An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter? (April 25, 2003). FEDS Working Paper No. 2003-42. Available at SSRN: https://ssrn.com/abstract=445540 or http://dx.doi.org/10.2139/ssrn.445540

Christopher T. Downing (Contact Author)

BlackRock ( email )

400 Howard Street
San Francisco, CA 94105
United States

Richard H. Stanton

University of California, Berkeley - Haas School of Business ( email )

Haas School of Business
545 Student Services Building #1900
Berkeley, CA 94720-1900
United States
(510) 642-7382 (Phone)
(510) 643-1412 (Fax)

Nancy E. Wallace

University of California, Berkeley - Real Estate Group ( email )

Berkeley, CA 94720-1900
United States

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