• We test the extent to which the option approach can explain default and prepayment behavior; evaluate the practical importance of modeling both options simultaneously; and model the unobserved heterogeneity of borrowers in the home mortgage market.
• Our results show that the option model, in its most straightforward version, does a good job of explaining default and prepayment; but it is not enough by itself.
• The simultaneity of the options is very important empirically in explaining behavior. Forecasts which ignore the interdependence between default and prepayment risks and which estimate these two risks separately lead to serious errors in estimating the default risk.
• The results also show that there exists significant heterogeneity among mortgage borrowers. Ignoring this heterogeneity results in serious errors in estimating the prepayment behavior of homeowners.
• Further, the results suggest that, holding other things constant, those who have chosen high initial LTV loans are more likely to exercise options in the mortgage market — prepayment as well as default. It appears that the initial LTV ratio, known at the time mortgages are issued, may well reflect investor preferences for risk in the market for mortgages on owner-occupied housing. Finally, unemployment and divorce rates have significant effects on default.
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