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. 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.

Introduction
The residential mortgage-backed security (MBS) market is one of the largest and fastest growing bond markets in the United States. Not only are MBS thus worth studying in their own right, but the easy availability of data, their simple structure compared with many other forms of debt, and the lack of uncertainty regarding recovery rates in the event of default make them attractive for studying and testing models of defaultable debt pricing more generally.

Author: Chris Downing, Richard Stanton, and Nancy Wallace

Source: Lancaster University Management School

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