Speaker: Mikhail Chernov, UCLA
Title: Macroeconomic-driven Prepayment Risk and the Valuation of Mortgage-Backed Securities
Abstract: We introduce a reduced-form modeling framework for mortgage-backed securities in which we solve for the implied prepayment function from the cross section of market prices. From the implied prepayment function, we find that prepayment rates are driven not only by interest rates, but also by two macroeconomic factors: turnover and rate response. Intuitively, turnover represents prepayments for exogenous reasons like employment-related moves, household income shocks, and foreclosures, while rate response reflects frictions faced by borrowers in refinancing into a lower rate. We find that the implied turnover and rate response measures are in fact significantly related to macroeconomic measures such as consumption growth, the unemployment rate, housing values, credit availability, and market uncertainty. Implied prepayments are substantially higher than actual prepayments, providing direct evidence of significant prepayment risk premia in mortgage-backed security prices. We analyze the properties of the prepayment risk premium and find that it is almost entirely due to compensation for turnover risk. We also find evidence that mortgage-backed security prices were significantly affected by Fannie Mae credit risk and the Federal Reserve’s Quantitative Easing Programs.
Bio: Professor of Finance Mikhail Chernov focuses on macro-based asset pricing, derivatives, fixed income and financial econometrics. “My research could be characterized as measurement of various risks that financial markets are facing, and understanding how these risks could translate into expected returns,” he says. “My particular focus is on the importance of market crashes, private and sovereign defaults, and unexpected changes in policy — events that may occur infrequently, but whose impact can be devastating on financial markets and on the economy overall.” Chernov’s academic publications have earned him numerous awards.