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Asian Review of Financial Research Vol.27 No.3 pp.383-422
The Effect of House Prices on Mortgage Prepayment in Korea : A Two-Factor Structural Approach
Young Ho Eom Professor, School of Business, Yonsei University
Youngha Han NICE Pricing and Information, Inc.
Jaehoon Hahn* Associate Professor, School of Business, Yonsei University
Key Words : Mortgage Prepayment,Default Option,Interest Rate,House Price,Structural Models


We estimate a two-factor structural mortgage valuation model using data on pool-level termination rates for fixed-rate mortgage loans issued by the Korea Housing Finance Corporation (KHFC) between 2004 and 2008. Our model is a modified version of that proposed by Downing, Stanton, and Wallace (DSW, 2005), in which borrowers rationally decide when to prepay and default in response to changes in house prices as well as interest rates. DSW (2005) find that incorporating house price movements into the model significantly improves its ability to match historical prepayment data over Stanton's (1995) one-factor (interest rate only) model. In DSW (2005), house price changes are modeled to affect borrowers' termination behavior only when prices decline by increasing the value of default option, but this particular specification does not bode well for our Korean sample period, during which house prices did not experience substantial or sharp declines. Consequently, we modify DSW's (2005) two-factor model so that house price movements influence termination behavior when prices increase as well as when prices decline. In contrast to the structural model used in this paper, previous empirical research on mortgage prepayment in Korea has mostly used statistical models, in which termination behavior is modeled as a function of a set of exogenous variables such as interest rates and house prices that represent the factors affecting prepayment and default. While such statistical approach may produce estimated prepayment rates that are closer to the historical data, its out-of-sample forecasting power is likely to be low, and the model is not suitable for pricing mortgage-backed securities. The structural approach taken in this study, on the other hand, models prepayment and default as a rational borrower's optimal responses to the changes in interest rates and house prices that represent the model's state variables. Such structural models should perform better out of sample than statistical models, and they can be used in the valuation of mortgage-backed securities. The mortgage prepayment data used in this study are from 34 pools of fixed-rate mortgage loans (called Bogeumjari loans) issued by the KHFC. The sample period is from June 2004 to December 2010, and the prepayment rates at the pool-level, as published monthly by the KHFC, are used. The empirical results show that both interest rates and house price changes significantly affect prepayment rates. In particular, house prices and prepayment rates have a positive association, consistent with Park and Bang (2011) and Choi and Kim (2011), who use statistical models. In addition, incorporating house price movements into the model improves its performance in matching historical prepayment rates, compared to the model in which only interest rate movements are considered. The results of Davidson and MacKinnon's (1981) J-test selecting between non-nested models show that the two-factor specification that includes house prices and interest rates is better for estimating prepayment rates than the one-factor (interest rate) specification. Moreover, we find that the two-factor model produces prepayment forecasts that are closer to the historical data than the one-factor model in an out-of-sample test. In a structural model, mortgage terminations (prepayment or default) are the result of borrowers' optimizing behavior, and house price movements can affect the borrowers' termination behavior as follows. When house prices fall, the value of the default option implicitly held by the borrower increases. And the movements in the value of the default option significantly affect the value of the borrower's prepayment option and therefore, the likelihood of prepayment. However, we find that prepayment rates decrease with declining house prices. The house prices in Korea experienced some declines during our sample period, but not by any substantial degree. Our finding of lower prepayment rates in times of declining house prices is similar to Mattey and Wallace (2001), who find that weak house prices tend to depress refinancing and prepayments. When house prices increase, so does the collateral value of the houses and the value of the borrower's equity, which influences the likelihood of prepayment if, for example, the borrower wants to cash out some of the increase in equity. This argument is consistent with the higher prepayment rates during times of increasing house prices found in this paper. More specifically, the period of increasing house prices in our sample is from late 2006 to early 2007, which coincides with rising interest rates. Despite the rising interest rates and penalties for prepayment, prepayment rates during that period increased in close association with rising house prices, suggesting that both interest rates and changes in house prices significantly affect mortgage prepayment rates in Korea.
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