Unobserved Heterogeneity and its Effects on Mortgage Options

Abstract

This paper extends the literature on modeling unobserved heterogeneity among mortgage holders and investigates reasons for non-optimal exercising of mortgage termination options: prepayment and default. Using a large sample of diversified population of prime and Alt-A loans, the research shows that unobserved heterogeneity can be substantially reduced after incorporating expanded list of covariates, including time-varying measures of borrowers creditworthiness. The research further shows that a more accurate classification of borrowers into various risk groups can be obtained by increasing number of mass points used to approximate the unknown distribution of unobserved heterogeneity parameters. It also highlights challenges one might face when trying to impose simplifying parametric assumptions on the joint distribution of unobserved heterogeneity.

JEL Classification: G2