An Analysis of Ex-Ante Probabilities of Mortgage Prepayment and Default

Abstract

Observed mortgage prepayment and default rates have been far different than the ruthless option exercise rates predicted by contingent claims models of mortgage pricing. The discrepancies have been attributed to both the competing risk nature of prepayment and default and to transactions costs. This paper tries a different means of reconciliation. We introduce a third stochastic process, household income, to the usual pricing model that includes only the spot interest rate and the house price. The role of mortgage underwriting constraints in governing mortgage behavior is also modeled. Numerical results show that the theoretical ex-ante prepayment and default rates in the more general model come much closer to historical experience.

JEL Classification: G21