An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?
Article first published online: 16 NOV 2005
Real Estate Economics
Volume 33, Issue 4, pages 681–710, December 2005
How to Cite
Downing, C., Stanton, R. and Wallace, N. (2005), An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?. Real Estate Economics, 33: 681–710. doi: 10.1111/j.1540-6229.2005.00135.x
- Issue published online: 16 NOV 2005
- Article first published online: 16 NOV 2005
This article develops a two-factor structural mortgage pricing model in which rational mortgage-holders choose when to prepay and default in response to changes in both interest rates and house prices. We estimate the model using comprehensive data on the pool-level termination rates for Freddie Mac Participation Certificates issued between 1991 and 2002. The model exhibits a statistically and economically significant improvement over the nested one-factor (interest-rate only) model in its ability to match historical prepayment data. Moreover, the two-factor model produces origination prices that are significantly closer to those quoted in the to-be-announced market than the one-factor model. Our results have important implications for hedging mortgage-backed securities.