IDEAS home Printed from https://ideas.repec.org/p/cdl/bphupl/qt85q0w8xj.html
   My bibliography  Save this paper

Woodhead Behavior and the Pricing of Residential Mortgages

Author

Listed:
  • Deng, Yongheng
  • Quigley, John M.

Abstract

Mortgage terminations arise because borrowers exercise options. This paper investigates the apparently irrational behavior of those borrowers who do not terminate their mortgages even when the exercise value of the option is deeply in the money. We develop an option-based empirical model to analyze this phenomenon -- the behavior of irrational or boundedly rational “woodheads.” Of course we do not observe “woodheads” explicitly in any body of data. Instead, we analyze the correlates of unobserved heterogeneity within a large sample of mortgage holders. We develop a three-stage maximum likelihood (3SML) estimator using martingale transforms to estimate the competing risks of mortgage prepayment and default, recognizing unobserved heterogeneity which is due in part to the behavior of “woodheads.” The extended model is clearly superior to alternatives on statistical grounds. We then analyze the economic implications of this more powerful model. We analyze the predictions of the model for the valuation and pricing of mortgage pools and mortgage-backed securities. Based upon an extensive Monte Carlo simulation, we find that the 3SML model yields prices for seasoned mortgage pools that deviate by 0.7 to 2 percent from more primitive estimates. The results indicate the empirical importance of heterogeneity and the implications of non-optimizing behavior for the valuation and pricing of mortgages and mortgage-backed securities.

Suggested Citation

  • Deng, Yongheng & Quigley, John M., 2004. "Woodhead Behavior and the Pricing of Residential Mortgages," Berkeley Program on Housing and Urban Policy, Working Paper Series qt85q0w8xj, Berkeley Program on Housing and Urban Policy.
    • Handle: RePEc:cdl:bphupl:qt85q0w8xj
    as

    Download full text from publisher

    File URL: https://www.escholarship.org/uc/item/85q0w8xj.pdf;origin=repeccitec
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, vol. 55(5), pages 1943-1978, October.
    2. Barberis, Nicholas & Shleifer, Andrei & Vishny, Robert, 1998. "A model of investor sentiment," Journal of Financial Economics, Elsevier, vol. 49(3), pages 307-343, September.
    3. Deng, Yongheng, 1997. "Mortgage Termination: An Empirical Hazard Model with a Stochastic Term Structure," The Journal of Real Estate Finance and Economics, Springer, vol. 14(3), pages 309-331, May.
    4. Karl E. Case & Robert J. Shiller, 1987. "Prices of single-family homes since 1970: new indexes for four cities," New England Economic Review, Federal Reserve Bank of Boston, issue Sep, pages 45-56.
    5. Heckman, James J. & Singer, Burton, 1984. "Econometric duration analysis," Journal of Econometrics, Elsevier, vol. 24(1-2), pages 63-132.
    6. Green, Jerry & Shoven, John B, 1986. "The Effects of Interest Rates on Mortgage Prepayments," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 18(1), pages 41-59, February.
    7. Stanton, Richard Henry, 1996. "Unobservable Heterogeneity and Rational Learning: Pool-Specific versus Generic Mortgage-Backed Security Prices," The Journal of Real Estate Finance and Economics, Springer, vol. 12(3), pages 243-263, May.
    8. Hall, Arden, 2000. "Controlling for Burnout in Estimating Mortgage Prepayment Models," Journal of Housing Economics, Elsevier, vol. 9(4), pages 215-232, December.
    9. Stanton, Richard, 1995. "Rational Prepayment and the Valuation Mortgage-Backed Securities," The Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 677-708.
    10. James Annable, 1984. "Analysis," Challenge, Taylor & Francis Journals, vol. 27(2), pages 59-61, May.
    11. Archer, Wayne R. & Ling, David C. & McGill, Gary A., 1996. "The effect of income and collateral constraints on residential mortgage terminations," Regional Science and Urban Economics, Elsevier, vol. 26(3-4), pages 235-261, June.
    12. Todd R. Stinebrickner, 1999. "Estimation Of A Duration Model In The Presence Of Missing Data," The Review of Economics and Statistics, MIT Press, vol. 81(3), pages 529-542, August.
    13. Kau, James B. & Keenan, Donald C. & Muller III, Walter J. & Epperson, James F., 1995. "The Valuation at Origination of Fixed-Rate Mortgages with Default and Prepayment," The Journal of Real Estate Finance and Economics, Springer, vol. 11(1), pages 5-36, July.
    14. Eduardo S. Schwartz & Walter N. Torous, 1993. "Mortgage Prepayment and Default Decisions: A Poisson Regression Approach," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 21(4), pages 431-449, December.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Hidetoshi Nakagawa & Tomoaki Shouda, 2004. "Analyses of Mortgage-Backed Securities Based on Unobservable Prepayment Cost Processes," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 11(3), pages 233-266, September.
    2. Downing, Chris & Stanton, Richard & Wallace, Nancy E., 2003. "An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?," Research Program in Finance, Working Paper Series qt2qb613r5, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
    3. Glaeser, Edward L., 2014. "Understanding housing: The intellectual legacy of John Quigley," Regional Science and Urban Economics, Elsevier, vol. 47(C), pages 3-12.
    4. Danny Ben-Shahar, 2008. "Default, Credit Scoring, and Loan-to-Value: a Theoretical Analysis under Competitive and Non-Competitive Mortgage Markets," Journal of Real Estate Research, American Real Estate Society, vol. 30(2), pages 161-190.
    5. Sebastian Barnes & Gregory Thwaites, 2005. "'Real-world' mortgages, consumption volatility and the low inflation environment," Bank of England working papers 273, Bank of England.
    6. Sumit Agarwal & Richard J. Rosen & Vincent W. Yao, 2013. "Why do borrowers make mortgage refinancing mistakes?," Working Paper Series WP-2013-02, Federal Reserve Bank of Chicago.
    7. Andreas Fuster & Paul S. Willen, 2010. "$1.25 Trillion is still real money : some facts about the effects of the Federal Reserve’s mortgage market investments," Public Policy Discussion Paper 10-4, Federal Reserve Bank of Boston.
    8. Kristopher Gerardi & Adam Hale Shapiro & Paul S. Willen, 2009. "Decomposing the foreclosure crisis: House price depreciation versus bad underwriting," FRB Atlanta Working Paper 2009-25, Federal Reserve Bank of Atlanta.
    9. Enrico De Giorgi, 2002. "An Intensity Based Non-Parametric Default Model for Residential Mortgage Portfolios," Risk and Insurance 0209001, University Library of Munich, Germany, revised 09 Sep 2002.
    10. Khandani, Amir E. & Lo, Andrew W. & Merton, Robert C., 2013. "Systemic risk and the refinancing ratchet effect," Journal of Financial Economics, Elsevier, vol. 108(1), pages 29-45.
    11. Chris Downing & Richard Stanton & Nancy Wallace, 2003. "An empirical test of a two-factor mortgage valuation model: how much do house prices matter?," Finance and Economics Discussion Series 2003-42, Board of Governors of the Federal Reserve System (U.S.).
    12. Sumit Agarwal & Brent W. Ambrose & Souphala Chomsisengphet, 2008. "Determinants of automobile loan default and prepayment," Economic Perspectives, Federal Reserve Bank of Chicago, vol. 32(Q III), pages 17-28.
    13. (David) Ho, Kim Hin & Su, Huiyong, 2006. "Structural prepayment risk behavior of the underlying mortgages for residential mortgage life insurance in a developing market," Journal of Housing Economics, Elsevier, vol. 15(3), pages 257-278, September.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Michael LaCour-Little & Michael Marschoun & Clark L. Maxam, 2002. "Improving Parametric Mortgage Prepayment Models with Non-parametric Kernel Regression," Journal of Real Estate Research, American Real Estate Society, vol. 24(3), pages 299-328.
    2. Agarwal, Sumit & Ambrose, Brent W. & Chomsisengphet, Souphala & Liu, Chunlin, 2006. "An empirical analysis of home equity loan and line performance," Journal of Financial Intermediation, Elsevier, vol. 15(4), pages 444-469, October.
    3. Nicholas Sharp & Paul Johnson & David Newton & Peter Duck, 2009. "A New Prepayment Model (with Default): An Occupation-time Derivative Approach," The Journal of Real Estate Finance and Economics, Springer, vol. 39(2), pages 118-145, August.
    4. Sumit Agarwal & Yongheng Deng & Jia He, 2020. "Time Preferences, Mortgage Choice and Mortgage Default," International Real Estate Review, Global Social Science Institute, vol. 23(2), pages 151-187.
    5. Che-Chun Lin & Ting-Heng Chu & Larry J. Prather & Perry Wang, 2005. "Mortgage Curtailment and Default," International Real Estate Review, Global Social Science Institute, vol. 8(1), pages 95-109.
    6. Sumit Agarwal & Yongheng Deng & Jia He, 2020. "Time Preferences, Mortgage Choice and Mortgage Default," International Real Estate Review, Global Social Science Institute, vol. 23(2), pages 777-813.
    7. Ahmad, F. & Hambly, B.M. & Ledger, S., 2018. "A stochastic partial differential equation model for the pricing of mortgage-backed securities," Stochastic Processes and their Applications, Elsevier, vol. 128(11), pages 3778-3806.
    8. Xudong An & Yongheng Deng & Eric Rosenblatt & Vincent Yao, 2012. "Model Stability and the Subprime Mortgage Crisis," The Journal of Real Estate Finance and Economics, Springer, vol. 45(3), pages 545-568, October.
    9. Yongheng Deng & Della Zheng & Changfeng Ling, 2005. "An Early Assessment of Residential Mortgage Performance in China," The Journal of Real Estate Finance and Economics, Springer, vol. 31(2), pages 117-136, September.
    10. Sumit Agarwal & John C. Driscoll & David I. Laibson, 2013. "Optimal Mortgage Refinancing: A Closed‐Form Solution," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(4), pages 591-622, June.
    11. Ran Deng & Shermineh Haghani, 2017. "FHA Loans in Foreclosure Proceedings: Distinguishing Sources of Interdependence in Competing Risks," JRFM, MDPI, vol. 11(1), pages 1-15, December.
    12. Ahmad, Ferhana & Shehzad, Choudhry Tanveer, 2024. "The role of interest rate environment in mortgage pricing," International Review of Economics & Finance, Elsevier, vol. 89(PA), pages 225-245.
    13. Deng, Yongheng & Quigley, John M. & Van Order, Robert & Mac, Freddie, 1996. "Mortgage default and low downpayment loans: The costs of public subsidy," Regional Science and Urban Economics, Elsevier, vol. 26(3-4), pages 263-285, June.
    14. Yongheng Deng & Peng Liu, 2009. "Mortgage Prepayment and Default Behavior with Embedded Forward Contract Risks in China’s Housing Market," The Journal of Real Estate Finance and Economics, Springer, vol. 38(3), pages 214-240, April.
    15. Sumit Agarwal & Richard J. Rosen & Vincent W. Yao, 2013. "Why do borrowers make mortgage refinancing mistakes?," Working Paper Series WP-2013-02, Federal Reserve Bank of Chicago.
    16. Congjin Zhou & Guojing Wang & Yinghui Dong & Pin Wang, 2024. "The Valuation at Origination of Mortgages with Full Prepayment and Default Risks," Methodology and Computing in Applied Probability, Springer, vol. 26(2), pages 1-26, June.
    17. Hartarska, Valentina M. & Gonzalez-Vega, Claudio, 2003. "Credit Counseling and Mortgage Termination by Low-Income Households," 2003 Regional Committee NCT-194, October 6-7, 2003; Kansas City, Missouri 132518, Regional Research Committee NC-1014: Agricultural and Rural Finance Markets in Transition.
    18. Lee, Pei-Ting & Rosenfield, Donald B., 2005. "When to refinance a mortgage: A dynamic programming approach," European Journal of Operational Research, Elsevier, vol. 166(1), pages 266-277, October.
    19. John Clapp & Yongheng Deng & Xudong An, 2005. "Unobserved heterogeneity in Models of Competing Mortgage Termination Risks," Working Paper 8585, USC Lusk Center for Real Estate.
    20. Hyeongjun Kim & Hoon Cho & Doojin Ryu, 2018. "Characteristics of Mortgage Terminations: an Analysis of a Loan-Level Dataset," The Journal of Real Estate Finance and Economics, Springer, vol. 57(4), pages 647-676, November.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:cdl:bphupl:qt85q0w8xj. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Lisa Schiff (email available below). General contact details of provider: https://edirc.repec.org/data/ibbrkus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.