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Woodhead Behavior and the Pricing of Residential Mortgages

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  • Yongheng Deng
  • John M. Quigley

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 "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 an error correction maximum likelihood (ECML) 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 ECML model yields prices for seasoned mortgage pools that deviate by 0.3 to almost 3.0 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.

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  • Yongheng Deng & John M. Quigley, 2003. "Woodhead Behavior and the Pricing of Residential Mortgages," Working Paper 8616, USC Lusk Center for Real Estate.
    • Handle: RePEc:luk:wpaper:8616
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    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. 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.
    4. 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.
    5. 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.
    6. 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.
    7. 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.).
    8. Glaeser, Edward L., 2014. "Understanding housing: The intellectual legacy of John Quigley," Regional Science and Urban Economics, Elsevier, vol. 47(C), pages 3-12.
    9. Sebastian Barnes & Gregory Thwaites, 2005. "'Real-world' mortgages, consumption volatility and the low inflation environment," Bank of England working papers 273, Bank of England.
    10. 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.
    11. (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.
    12. 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.
    13. 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.

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