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 empirical turnover and rate response measures are both significantly related to macroeconomic measures, suggesting that these factors represent a source of systematic risk. Consistent with this, we find that 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.
We are grateful for the comments and suggestions of Vineer Bhansali, Nina Boyarchenko, Michael Brennan, Karen Chaltikian, Andrea Eisfeldt, Stuart Gabriel, James Gammill, David Langor, David Lucca, Xiaoxian Luo, Carolina Marquez, Ravi Mattu, Emmanuel Vallod, Victor Wong, and seminar participants at Blackrock, Boston College, Emory University, The Fink Center for Finance and Investments, Georgetown University, Georgia Institute of Technology, the University of British Columbia, the Spring 2015 Journal of Investment Management Conference, and UCLA. All errors are our responsibility. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Mikhail Chernov & Brett R. Dunn & Francis A. Longstaff, 2018. "Macroeconomic-Driven Prepayment Risk and the Valuation of Mortgage-Backed Securities," The Review of Financial Studies, vol 31(3), pages 1132-1183. citation courtesy of