Working Paper: NBER ID: w22096
Authors: Mikhail Chernov; Brett R. Dunn; Francis A. Longstaff
Abstract: 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.
Keywords: Mortgage-Backed Securities; Prepayment Risk; Macroeconomic Factors
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Implied prepayment rates (E43) | influenced by interest rates (E43) |
| Implied prepayment rates (E43) | influenced by turnover (J63) |
| Implied prepayment rates (E43) | influenced by rate response (E43) |
| Empirical turnover and rate response measures (J63) | related to macroeconomic measures (E01) |
| Prepayment risk premium (G19) | due to turnover risk (J63) |
| Implied prepayments (E41) | higher than actual prepayments (E49) |