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The refinancing threshold pricing model: An economic approach to valuing MBS

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Abstract

Investigation of MBS prepayment data indicates that mortgagors have different interest rate levels, or thresholds, at which they exercise their option to prepay their mortgage. In order to properly value an MBS with heterogeneous mortgagors, Merrill Lynch has developed the Refinancing Threshold Pricing Model (RTP). The RTP model focuses on the refinancing decision of the mortgagor when pricing the mortgage pool. The model divides each pool into groups of mortgagors who share similar refinancing costs. Using market data, the RTP model endogenously determines both the implied costs that mortgagors face, as well as the proportion of the MBS pool in each refinancing cost group. In addition to determining pool value, the RTP model also calculates MBS duration, dP/dY and convexity. Comparison between RTP model values and actual market data reveals a strong correlation. The RTP has a wide range of applications, including valuing 15-year and 30-year conventional MBS; pricing interest-only (IO)/principal-only (PO) derivative MBS; determining new versus seasoned MBS price spreads; and valuing specific MBS pools.

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References

  • Cox, John C.; Ingersoll, Jonathan E.; and Ross, Stephen A. “A Theory of the Term Structure of Interest Rates.” Econometrica 53 (1985), 385–407.

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  • Dunn, Kenneth B., and Spatt, Chester S. “The Effect of Refinancing Costs and Market Imperfections on the Optimal Call Strategy and Pricing of Debt Contracts.” Carnegie-Mellon University, Working paper, March 1986.

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Author information

Authors and Affiliations

  1. Mortgage-Backed Securities Research, Merrill Lynch Mortgage Capital, Inc., USA

    Andrew S. Davidson

  2. Mortgaged-Backed Securities Research, Merrill Lynch Mortgage Capital, Inc., USA

    Michael D. Herskovitz

  3. University of Utah, Utah, USA

    Leonard D. Van Drunen PhD. (Assistant Professor of Finance)

Authors
  1. Andrew S. Davidson
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  2. Michael D. Herskovitz
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  3. Leonard D. Van Drunen PhD.
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Additional information

The information set forth was obtained from sources we believe reliable, but we do not guarantee its accuracy. Neither the information, nor any opinion expressed constitutes a solicitation by us for the purchase or sale of any securities or commodities. Merrill Lynch, Pierce, Fenner & Smith, Inc. or its affiliates may have either a long or short position in, and may buy and sell for its own account or the accounts of others, these securities.

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Davidson, A.S., Herskovitz, M.D. & Van Drunen, L.D. The refinancing threshold pricing model: An economic approach to valuing MBS. J Real Estate Finan Econ 1, 117–130 (1988). https://doi.org/10.1007/BF00152568

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  • DOI: https://doi.org/10.1007/BF00152568

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