Prepayment, Default, and the Valuation of Mortgage Pass-Through Securities

This article investigates the interaction of prepayment and default decisions in the valuation of mortgage pass-through securities. Even though a mortgage pass-through security is typically guaranteed by a financial intermediary, default decisions affect the timing of its cash flows and, therefore, its value. The authors also investigate the equilibrium valuation of the default insurance provided by the financial intermediary. The equilibrium insurance fee varies with prevailing interest rates, with prepayment possibilities, and, most significantly, with the volatility and value of the underlying mortgaged house. To the extent that a fixed insurance fee is charged, the authors' analysis suggests that default insurance is not properly priced.