Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities

We introduce a reduced-form modeling framework for mortgage- backed securities in which we solve for the implied prepayment function from the cross section of market prices. From the implied prepayment function, we find that prepayment rates are driven not only by interest rates, but also by two macroeconomic factors: turnover and rate response. Intuitively, turnover represents prepayments for exogenous reasons like employment-related moves, household income shocks, and foreclosures, while rate response reflects frictions faced by borrowers in refinancing into a lower rate. We find that the implied turnover and rate response measures are in fact significantly related to macroeconomic measures such as consumption growth, the unemployment rate, housing values, credit availability, and market uncertainty. Implied prepayments are substantially higher than actual prepayments, providing direct evidence of significant prepayment risk premia in mortgage-backed security prices. We analyze the properties of the prepayment risk premium and find that it is almost entirely due to compensation for turnover risk. We also find evidence that mortgage- backed security prices were significantly affected by Fannie Mae credit risk and the Federal Reserve’s Quantitative Easing Programs.

[1]  Haoxiang Zhu,et al.  Mortgage Dollar Roll , 2018, The Review of Financial Studies.

[2]  P. Gao,et al.  Liquidity in a Market for Unique Assets: Specified Pool and To-Be-Announced Trading in the Mortgage-Backed Securities Market: Liquidity in a Market for Unique Assets , 2017 .

[3]  Andrea L. Eisfeldt,et al.  Prepayment Risk and Expected MBS Returns , 2016 .

[4]  P. Gao,et al.  Liquidity in a Market for Unique Assets: Specified Pool and TBA Trading in the Mortgage Backed Securities Market , 2016 .

[5]  F. Fabozzi,et al.  Hedging Agency Mortgage-Related Securities , 2016 .

[6]  F. Fabozzi.  The Handbook of Mortgage-Backed Securities: 7th Edition , 2016 .

[7]  Philippe Mueller,et al.  Mortgage Risk and the Yield Curve , 2015 .

[8]  John Kandrac.  Have Federal Reserve MBS purchases affected market functioning , 2013 .

[9]  F. Longstaff,et al.  Disagreement and Asset Prices , 2012 .

[10]  Andrea Vedolin.  Uncertainty and Leveraged Lucas Trees: The Cross Section of Equilibrium Volatility Risk Premia , 2012 .

[11]  Glenn D. Rudebusch,et al.  The Response of Interest Rates to US and UK Quantitative Easing , 2012 .

[12]  B. Sack,et al.  The Financial Market Effects of the Federal Reserve ’ s Large-Scale Asset Purchases ∗ , 2008 .

[13]  Howard Corb.  Interest Rate Swaps and Other Derivatives , 2012 .

[14]  Glenn D. Rudebusch,et al.  The Response of Interest Rates to US and UK Quantitative Easing , 2012 .

[15]  Andrew Ang,et al.  Systemic Sovereign Credit Risk: Lessons from the U.S. and Europe , 2011 .

[16]  E. Perotti,et al.  A Pigovian Approach to Liquidity Regulation , 2011 .

[17]  A. Krishnamurthy,et al.  The Effects of Quantitative Easing on Interest Rates , 2011 .

[18]  J. Vickery,et al.  Federal Reserve Bank of New York Economic Policy Review Contents Articles : 1 TBA Trading and Liquidity in the Agency MBS Market , 2013 .

[19]  Kay Giesecke,et al.  Corporate Bond Default Risk: A 150-Year Perspective , 2010 .

[20]  K. Singleton,et al.  Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads , 2008 .

[21]  K. Singleton,et al.  How Sovereign is Sovereign Credit Risk? , 2007 .

[22]  V. Linetsky,et al.  INTENSITY‐BASED VALUATION OF RESIDENTIAL MORTGAGES: AN ANALYTICALLY TRACTABLE MODEL , 2007 .

[23]  M. Ali,et al.  Some Variants of the Controlled Random Search Algorithm for Global Optimization , 2006 .

[24]  Y. Goncharov.  AN INTENSITY-BASED APPROACH TO THE VALUATION OF MORTGAGE CONTRACTS AND COMPUTATION OF THE ENDOGENOUS MORTGAGE RATE , 2006 .

[25]  F. Yu,et al.  Risk and Return in Fixed Income Arbitrage: Nickels in Front of a Steamroller? , 2006 .

[26]  F. Longstaff.  Borrower Credit and the Valuation of Mortgage-Backed Securities , 2005 .

[27]  Chester Spatt,et al.  The Effect of Refinancing Costs and Market Imperfections on the Optimal Call Strategy and the Pricing of Debt Contracts , 2005 .

[28]  N. Wallace.  Innovations in Mortgage Modeling: An Introduction , 2005 .

[29]  Alexander Levin,et al.  Prepayment Risk-and Option-Adjusted Valuation of MBS , 2005 .

[30]  X. Gabaix,et al.  Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market , 2005 .

[31]  V. Linetsky.  THE SPECTRAL DECOMPOSITION OF THE OPTION VALUE , 2004 .

[32]  Fan Yu,et al.  DEFAULT RISK AND DIVERSIFICATION: THEORY AND EMPIRICAL IMPLICATIONS , 2003 .

[33]  Stijn Van Nieuwerburgh,et al.  Housing Collateral, Consumption Insurance and Risk Premia: An Empirical Perspective , 2003 .

[34]  N. Wallace,et al.  An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter? , 2003 .

[35]  Ming Huang,et al.  How Much of Corporate-Treasury Yield Spread is Due to Credit Risk? , 2002 .

[36]  J. Kau,et al.  Frictions, Heterogeneity and Optimality in Mortgage Modeling , 2002 .

[37]  M. Subrahmanyam,et al.  Pricing and Hedging Interest Rate Options: Evidence from Cap-Floor Markets , 2002 .

[38]  P. Klaassen,et al.  The Performance of Multi-Factor Term Structure Models for Pricing and Hedging Caps and Swaptions , 2002, Journal of Financial and Quantitative Analysis.

[39]  Charles A. CaponeJr..  Introduction to the Special Issue on Mortgage Modeling , 2001 .

[40]  D. Brigo,et al.  Interest Rate Models - Theory and Practice: With Smile, Inflation and Credit , 2001 .

[41]  D. Duffie,et al.  Modeling term structures of defaultable bonds , 1999 .

[42]  John M. Quigley,et al.  Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options , 1999 .

[43]  N. Wallace,et al.  Mortgage Choice: What's the Point? , 1998 .

[44]  D. Duffie,et al.  An Econometric Model of the Term Structure of Interest-Rate Swap Yields , 1997 .

[45]  R. Ibbotson,et al.  Estimates of Smallstock Betas Are Much Too Low , 1997 .

[46]  Si Chen.  Understanding Option-Adjusted Spreads , 1996 .

[47]  Oren Cheyette.  Implied Prepayments , 1996 .

[48]  Richard Stanton.  Rational Prepayment and the Valuation of Mortgage-Backed Securities , 1995 .

[49]  Jacob Boudoukh,et al.  Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach , 1995 .

[50]  Walter N. Torous,et al.  Mortgage Prepayment and Default Decisions: A Poisson Regression Approach , 1993 .

[51]  J. Kau,et al.  A Generalized Valuation Model for Fixed-Rate Residential Mortgages , 1992 .

[52]  Alan G. White,et al.  Pricing Interest-Rate-Derivative Securities , 1990 .

[53]  F. Longstaff.  The valuation of options on yields , 1990 .

[54]  Sheridan Titman,et al.  Valuing Commercial Mortgages: An Empirical Investigation of the Contingent‐Claims Approach to Pricing Risky Debt , 1989 .

[55]  Eduardo S. Schwartz,et al.  Prepayment and the Valuation of Mortgage-Backed Securities , 1989 .

[56]  Richard Roll,et al.  Prepayments on fixed-rate mortgage-backed securities , 1989 .

[57]  F. Jamshidian.  An Exact Bond Option Formula , 1989 .

[58]  W. Newey,et al.  A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelationconsistent Covariance Matrix , 1986 .

[59]  Eduardo S. Schwartz,et al.  Determinants of GNMA Mortgage Prices , 1985 .

[60]  John J. McConnell,et al.  Valuation of GNMA Mortgage-Backed Securities , 1981 .

[61]  John J. McConnell,et al.  A Comparison of Alternative Models for Pricing GNMA Mortgage-Backed Securities , 1981 .

[62]  Oldrich A. Vasicek.  An equilibrium characterization of the term structure , 1977 .

[63]  D. Thornton.  QE: is there a portfolio balance effect? , 2014 .

[64]  S. Hanson.  Mortgage convexity ∗ , 2012 .

[65]  Donald C. Keenan,et al.  An Overview of the Option-Theoretic Pricing of Mortgages , 2001 .

[66]  L. Hayre.  Salomon Smith Barney guide to mortgage-backed and asset-backed securities , 2001 .

[67]  Walter N. Torous,et al.  Prepayment, Default, and the Valuation of Mortgage Pass-through Securities , 1992 .

[68]  J. Hull.  Options, Futures, and Other Derivatives , 1989 .

[69]  F. Fabozzi.  The Handbook of Mortgage-Backed Securities , 1985 .