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

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Author Info
Chris Downing
Richard Stanton
Nancy Wallace
Abstract

This article develops a two-factor structural mortgage pricing model in which rational mortgage-holders choose when to prepay and default in response to changes in both interest rates and house prices. We estimate the model using comprehensive data on the pool-level termination rates for Freddie Mac Participation Certificates issued between 1991 and 2002. The model exhibits a statistically and economically significant improvement over the nested one-factor (interest-rate only) model in its ability to match historical prepayment data. Moreover, the two-factor model produces origination prices that are significantly closer to those quoted in the to-be-announced market than the one-factor model. Our results have important implications for hedging mortgage-backed securities. Copyright 2005 by the American Real Estate and Urban Economics Association

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Article provided by American Real Estate and Urban Economics Association in its journal Real Estate Economics.

Volume (Year): 33 (2005)
Issue (Month): 4 (December)
Pages: 681-710
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Handle: RePEc:bla:reesec:v:33:y:2005:i:4:p:681-710

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  1. Xin Wang & Chris Downing, 2005. "Optimal Capital Structure and the Term Structure of Interest Rates," Computing in Economics and Finance 2005 38, Society for Computational Economics. [Downloadable!]
  2. Sumit Agarwal & John C. Driscoll & David Laibson, 2007. "Optimal Mortgage Refinancing: A Closed Form Solution," NBER Working Papers 13487, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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