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Pricing Mortgage-Backed Securities: Integrating Optimal Call and Empirical Models of Prepayment

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  • Wayne R. Archer
  • David C. Ling

Abstract

Residential mortgage borrowers frequently appear to behave suboptimally with respect to their mortgage prepayment options. Many borrowers fail to exercise even well-into-the-money options while others prepay when the call option is out-of-the-money. To account for these apparently suboptimal prepayments, the recent trend in mortgage-backed securities research has been away from optimal call valuation models, in which the decision to exercise is determined endoge-nously, in favor of models in which prepayment behavior is exogenously specified based on empirical estimation. This paper develops a rational model of mortgage prepayment which incorporates both types of "non-optimal" prepayment and retains endogenous call. This enables the model to disentangle and compare the separate effects of the interest rate call, impeded by transaction costs, and of non-interest-rate driven prepayment. In addition, by recognizing heterogenous borrower transaction costs, the model presents a way to account more precisely for the varying prepayment lags associated with well-into-the-money call options and to account for the phenomenon of "burnout" within a mortgage pool. The paper includes an empirical test of the unbiasedness of the integrated pricing model by comparing simulated prices from our theoretical model to observed prices on traded Fannie Mae and GNMA securities. Copyright American Real Estate and Urban Economics Association.

Suggested Citation

  • Wayne R. Archer & David C. Ling, 1993. "Pricing Mortgage-Backed Securities: Integrating Optimal Call and Empirical Models of Prepayment," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 21(4), pages 373-404.
  • Handle: RePEc:bla:reesec:v:21:y:1993:i:4:p:373-404
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    References listed on IDEAS

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    Cited by:

    1. Xudong An & John Clapp & Yongheng Deng, 2010. "Omitted Mobility Characteristics and Property Market Dynamics: Application to Mortgage Termination," The Journal of Real Estate Finance and Economics, Springer, vol. 41(3), pages 245-271, October.
    2. Archer, Wayne R. & Ling, David C. & McGill, Gary A., 1996. "The effect of income and collateral constraints on residential mortgage terminations," Regional Science and Urban Economics, Elsevier, vol. 26(3-4), pages 235-261, June.
    3. Sumit Agarwal & John C. Driscoll & David I. Laibson, 2013. "Optimal Mortgage Refinancing: A Closed‐Form Solution," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(4), pages 591-622, June.
    4. Agarwal, Sumit & Ambrose, Brent W. & Chomsisengphet, Souphala & Liu, Chunlin, 2006. "An empirical analysis of home equity loan and line performance," Journal of Financial Intermediation, Elsevier, pages 444-469.
    5. Lanot, Gauthier & Leece, David, 2010. "The Performance of UK Securitized Subprime Mortgage Debt: ‘Idiosyncratic’ Behaviour or Mortgage Design?," MPRA Paper 27137, University Library of Munich, Germany.
    6. Anthony Pennington-Cross & Souphala Chomsisengphet, 2007. "Subprime Refinancing: Equity Extraction and Mortgage Termination," Real Estate Economics, American Real Estate and Urban Economics Association, pages 233-263.
    7. Anthony Pennington-Cross & Souphala Chomsisengphet, 2007. "Subprime Refinancing: Equity Extraction and Mortgage Termination," Real Estate Economics, American Real Estate and Urban Economics Association, pages 233-263.
    8. Toshio Kimura & Naoki Makimoto, 2008. "Optimal Mortgage Refinancing with Regime Switches," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, pages 47-65.
    9. Agarwal, Sumit & Driscoll, John D. & Laibson, David I., 2012. "Optimal Mortgage Reï¬ nancing: A Closed Form Solution," Scholarly Articles 9918811, Harvard University Department of Economics.
    10. Archer, Wayne R. & Ling, David C. & McGill, Gary A., 1997. "Demographic versus Option-Driven Mortgage Terminations," Journal of Housing Economics, Elsevier, vol. 6(2), pages 137-163, June.
    11. Chih-Hsing Hung & Ming-Chi Chen & Shyh-Weir Tzang, 2012. "Modeling Mortgages with Prepayment Penalties," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 48(S3), pages 157-174, September.
    12. Charlier, E. & van Bussel, A., 2001. "Prepayment Behavior of Dutch Mortgagors : An Empirical Analysis," Discussion Paper 2001-64, Tilburg University, Center for Economic Research.
    13. Chih-Hsing Hung & Ming-Chi Chen & Shyh-Weir Tzang, 2012. "Modeling Mortgages with Prepayment Penalties," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 48(S3), pages 157-174, September.
    14. Richard K. Green & Susan M. Wachter, 2007. "The housing finance revolution," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 21-67.
    15. Harding, John P., 2000. "Mortgage Valuation with Optimal Intertemporal Refinancing Strategies," Journal of Housing Economics, Elsevier, vol. 9(4), pages 233-266, December.
    16. Agarwal, Sumit & Chomsisengphet, Souphala & Hassler, Olivier, 2005. "The impact of the 2001 financial crisis and the economic policy responses on the Argentine mortgage market," Journal of Housing Economics, Elsevier, vol. 14(3), pages 242-270, September.
    17. Stephen F. Thode, 2000. "CMOs, Duration Risk and a New Mortgage," Journal of Real Estate Research, American Real Estate Society, vol. 19(1), pages 73-103.

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