Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?
An Empirical Test of a Two-Factor Mortgage Valuation Model:
How Much Do House Prices Matter?
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. 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, and Nancy E. Wallace,
An Empirical Test of a Two-Factor Mortgage Valuation Model:
How Much Do House Prices Matter ? (link to 406 K, PDF file)
Chris Downing, Federal Reserve Board, Washington, DC
Richard Stanton, Haas School of Business, University of California, Berkeley
Nancy E. Wallace, Haas School of Business, University of California, Berkeley