Third party originators and mortgage prepayment risk: An agency problem?

Journal of Real Estate Research, The, 1999 by LaCour-Little, Michael, Chun, Georgory H

Literature Review

The mortgage market has evolved considerably over the past twenty years, with the evolution of a wide array of alternative instruments and the expansion of the secondary market, including a variety of mortgage-based derivatives. Researchers have recognized that contingent claims methodologies can provide important insights into market workings. A mortgage loan may be viewed as a fixed income instrument combined with American put and call options held by the borrower and written by the lender. The right to prepay the mortgage at any time is a call option at par; the ability to default on the mortgage at any time is a put option in which the mortgage is sold to the lender for the market value of the property. Prepayment options are more likely to be exercised when interest rates fall; default options are more likely to be exercised when house prices fall.'o Hendershott and Van Order (1987) provide a survey of representative pricing model results. Kau, Keenan, Mueller and Epperson (1992) develop a formal treatment of the valuation problem for fixed rate mortgages.

Research into mortgage prepayment has taken a number of approaches. Theoretical work focuses on valuation and optimal exercise of the embedded call option to prepay as rates fluctuate over time (Kau and Kim, 1991; Follain, Scott and Yang, 1992; and McConnell and Singh 1994). Methodological issues and modeling techniques are summarized in Kang and Zenios (1992). Empirical research often uses mortgage pool data, where loan level information is largely limited to pool type, issuer, time and weighted average note rate. Peters, Pinkus and Askin (1984), Richard and Roll (1988), Schwartz and Torous (1989, 1992) and Foster and Van Order (1990-1991) address single family residential mortgage prepayments using pool data; and Elmer and Haidorfer (1997) examine prepayments on multi-family mortgage backed securities.

Empirical research initially focused on the role of borrower demographic characteristics affecting mobility, in addition to the effect of interest rate movements (Green and Shoven, 1986; and Quigley, 1988). More recently, interest has focused on borrower characteristics that might impede refinancing, even when it may be optimal for the borrower to do so given prevailing mortgage rate levels (Peristiani, Bennett, Monsen, Peach and Raiff, 1997; Archer and Ling 1997; Archer, Ling and McGill, 1996; Green and LaCour-Little, 1998; and Crawford and Wu, 1998). Another recent trend in the literature is to explicitly model the competing risks of default and prepayment (Deng, Quigley and Van Order, 1996; and Abrahams, 1997).

While most mortgage bankers and Wall Street participants" in the mortgage bond market generally agree that wholesale, or TPO, loans exhibit greater prepayment speed than do retail loans, this article is the first known academic research on the topic. In the next section, we sketch out the basic economic argument for why we might expect to observe such a pattern. Chun and LaCour-Little (1998) develop a more complete formal treatment of the agency problem as it applies to contracts between lenders and third party originators and mortgage prepayment risk.