18. Modeling Mortgage Prepayments and Valuing Mortgages

Financial Theory (ECON 251)

A mortgage involves making a promise, backing it with collateral, and defining a way to dissolve the promise at prearranged terms in case you want to end it by prepaying. The option to prepay, the refinancing option, makes the mortgage much more complicated than a coupon bond, and therefore something that a hedge fund could make money trading. In this lecture we discuss how to build and calibrate a model to forecast prepayments in order to value mortgages. Old fashioned economists still make non-contingent forecasts, like the recent predictions that unemployment would peak at 8%. A model makes contingent forecasts. The old prepayment models fit a curve to historical data estimating how sensitive aggregate prepayments have been to changes in the interest rate. The modern agent based approach to modeling rationalizes behavior at the individual level and allows heterogeneity among individual types. From either kind of model we see that mortgages are very risky securities, even in the absence of default. This raises the question of how investors and banks should hedge them.

00:00 - Chapter 1. Review of Mortgages
03:20 - Chapter 2. Complications of Refinancing Mortgages
19:26 - Chapter 3. Non-contingent Forecasts of Mortgage Value
28:40 - Chapter 4. The Modern Behavior Rationalizing Model of Mortgage Value
54:07 - Chapter 5. Risk in Mortgages and Hedging

Complete course materials are available at the Open Yale Courses website: http://open.yale.edu/courses

This course was recorded in Fall 2009.