Mortgage terminations, heterogeneity and the exercise of mortgage options

As applied to the behavior of homeowners with mortgages, option theory pred icts that mortgage prepayment or default will be exercised if the call or p ut option is "in the money" by same specific amount. Our analysis: tests th e extent to which the option approach can explain default and prepayment be havior; evaluates the practical importance of modeling both options simulta neously; and models the unobserved heterogeneity of borrowers in the home m ortgage market. The paper presents a unified model of the competing risks o f mortgage termination by prepayment and default, considering the two hazar ds as dependent competing risks that are estimated jointly. It also account s for the unobserved heterogeneity among borrowers, and estimates the unobs erved heterogeneity simultaneously with the parameters and baseline hazards associated with prepayment and default Functions. Our results show that the option model, in its most straightforward version , does a good job of explaining default and prepayment, but it is not enoug h by itself. The simultaneity of the options is very important empirically in explaining behavior. The results also show that there exists significant heterogeneity among mortgage borrowers. Ignoring this heterogeneity result s in serious errors in estimating the prepayment behavior of homeowners.