Chapter 49 MBS VALUATION AND PREPAYMENTS. Abstract This paper not only provides a comparison of recent models in the valuation of mortgage-backed securities but also proposes an integrated model that addresses important issues of path-dependence, exogenous prepayment, transaction costs, mortgagors’ heterogeneity, and the housing devaluation effect. | Chapter 49 MBS VALUATION AND PREPAYMENTS . TED HONG Beyond Bond Inc. USA WEN-CHING WANG Robeco Investment Management USA Abstract This paper not only provides a comparison of recent models in the valuation of mortgage-backed securities but also proposes an integrated model that addresses important issues of path-dependence exogenous prepayment transaction costs mortgagors heterogeneity and the housing devaluation effect. Recent research can be categorized into two frameworks empirical and theoretical option pricing. Purely empirically derived models often consider estimation of the prepayment model and pricing of the mortgage-backed security as distinct problems and thus preclude explanation and prediction for the price behavior of the security. Some earlier theoretical models regard mortgage-backed securities as default-free callable bonds prohibiting the mortgagors from exercising the default put option and therefore induce bias on the pricing of mortgage-backed securities. Other earlier models assume homogeneity of mortgagors and consequently fail to address important issues of premium burnout effect and the path-dependence problem. The model proposed is a two-factor model in which the housing price process is incorporated to account for the effect of mortgagor s default and to capture the impact of housing devaluation. Default is correctly modeled in terms of its actual payoff through a guarantee to the investors of the security such that the discrepancy is eliminated by assuming mortgage securities as either default-free or unin sured. Housing prices have been rising at unsustainable rates nation wide especially along the coasts suggesting a possible substantial weakening in house appreciation at some point in the future. The effect of housing devaluation is specifically modeled by considering the possibility that the mortgagor might be restrained from prepayment even if interest rates make it advantageous to refinance. Mortgagors heterogeneity and the .
