an empirical test of a two-factor mortgage valuation model.pdf

An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter? Chris Downing, Richard Stanton and Nancy Wallace∗ April 25, 2003, 12:01pm 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. ∗This paper represents the views of the authors and does not necessarily represent the views of the Federal Reserve System or members of its staff. Please address correspondence to (Downing): Federal Reserve Board, Mail Stop 89, Washington, DC 20551. Phone: (202) 452-2378. Fax: (202) 452-5296. E- Mail: cdowning@. (Stanton): Haas School of Business, University of California at Berkeley, Berkeley, CA 94720. Phone: (510) 642-7382. Fax: (510) 643-1420. E-Mail: stanton@. (Wallace): Haas School of Business, University of Ca