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An empirical test of a two-factor mortgage valuation model: how much do house prices matter?

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  • Chris Downing
  • Richard Stanton
  • Nancy Wallace

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.

Suggested Citation

  • Chris Downing & Richard Stanton & Nancy Wallace, 2003. "An empirical test of a two-factor mortgage valuation model: how much do house prices matter?," Finance and Economics Discussion Series 2003-42, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2003-42
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    References listed on IDEAS

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    Cited by:

    1. Hidetoshi Nakagawa & Tomoaki Shouda, 2004. "Analyses of Mortgage-Backed Securities Based on Unobservable Prepayment Cost Processes," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 11(3), pages 233-266, September.
    2. John M. Clapp & Yongheng Deng & Xudong An, 2006. "Unobserved Heterogeneity in Models of Competing Mortgage Termination Risks," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 34(2), pages 243-273, June.
    3. Toru Sugimura, 2004. "Valuation of Residential Mortgage-Backed Securities with Default Risk Using an Intensity-Based Approach," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 11(2), pages 185-214, June.

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