Rational Prepayment and the Valuation of Mortgage-Backed Securities

Abstract

This article presents a new model of mortgage prepayments, based on rational decisions by mortgage holders. These mortgage holders face heterogeneous transaction costs, which are explicitly modeled. The model is estimated using a version of Hansen’s (1982) generalized method of moments, and is shown to capture many of the empirical features of mortgage prepayment. Estimation results indicate that mortgage holders act as though they face transaction costs that far exceed the explicit costs usually incurred on refinancing. They also wait an average of more than a year before refinancing, even when it is optimal to do so. The model fits observed prepayment behavior as well as the recent empirical model of Schwartz and Torous (1989) . Implications for pricing mortgage-backed securities are discussed.