Asia-Pacific Financial Markets 7: 189–204, 2000.

189
© 2000 Kluwer Academic Publishers. Printed in the Netherlands.

Pricing Mortgage-Backed Securities (MBS)

A Model Describing the Burnout Effect

TAKEAKI KARIYA 1 and MASAAKI KOBAYASHI 2

1 Institute of Economic Research, Kyoto University, Sakyoku, Kyoto 606-8501, Japan,
e-mail: kariya@keir.kyoto-u.ac.jp
2 IBJ-DL Financial Technology Co., Ltd., Otemachi First Square, 5-1, Otemachi 1-chrome,
Chiyoda-ku, Tokyo, 100-0004, Japan, e-mail: masa-kobayashi@fintec.co.jp

Abstract. This paper presents a pricing formula for MBSs and proposes a specific model for MBS
prices that describes the so-called burnout phenomenon of prepayments due to refinancing. A nu-
merical example of the model is demonstrated by Monte Carlo simulation. An estimation procedure
is also described.

Key words: MBS, GNMA, prepayment model, burnout effect, no-arbitrage value, heterogeneity of
mortgage pool.

1. Introduction
A mortgage-backed security (MBS) is a pass-through security structured in such a
way that all payments made by mortgage holders, except for servicing fees, go to
the investors who purchase the securities. It is often the case that the payments are
protected by a guaranty institution against the default risk of mortgagors.
In this paper, via a no-arbitrage pricing theory in discrete-time setting, we first
derive a valuing formula for such an MBS with this guaranty like the US GNMA,
FNMA, FHLMC, etc. for housing loans. A notable feature of such an MBS is that
mortgage holders are given the option of prepaying the loans at any time; hence,
the investors have a prepayment risk in addition to an interest risk. Prepayment can
occur abruptly due to refinancing when the mortgage interest rate drops greatly
relative to the initial rate. When this happens, investors lose opportunities to al-
locate the prepaid money in an environment of low interest rate. Prepayment due
to refinancing is considered a behavior based on the purely economic incentive
of borrowers. Prepayment also occurs when mortgage holders sell their houses.
They sell their houses either for economic reasons (the prices of their houses have
appreciated significantly) or for noneconomic reasons such as family problems,
job problems, etc. The prepayment due to these reasons is difficult to model unless
details of the borrowers are given as data during the loan period. In general, detailed
information on prepayment reasons in a specific pool of mortgage loans is not
available to the investors. Hence, we have to model prepayment behaviors based
on various available economic and demographic data or they simply treat it as an
additional spread in the discount function, which is typical in the ‘standard’ OAS
190 TAKEAKI KARIYA AND MASAAKI KOBAYASHI

(option-adjusted spread) model. Prepayment due to defaults is usually ignored,

because it is small in private housing loans.
There is a large body of literature on U.S. MBSs, both theoretical and empirical.
Among others, Schwartz and Torous (1989) empirically modeled prepayment as a
function of exogenous or explanatory variables in a regression model. This is a typ-
ical approach to fit an observed prepayment pattern, including the so-called burnout
phenomenon. The burnout phenomenon means that prepayments calm down after
a certain period even if the mortgage interest rate is smaller than the initial rate.
In modeling this phenomenon, a variety of approaches are taken in Wall Street
firms, which are quite different from firm to firm. Dunn and McConnell (1981a, b)
modeled the optimal prepayment strategy of a mortgage holder, where prepayment
was regarded as a call option in a continuous-time setting. But as the prepayment
behavior was treated as homogeneous in the pool, they did not treat the burnout
effect. This approach was followed by Timmis (1985), Dunn and Spatt (1986),
and Johnston and Van Drunen (1988), who included some frictional factors against
prepayment, such as cost and lag. Also, McConnell and Singh (1994) developed
a procedure for evaluating collateralized mortgage obligations. Stanton (1995) in-
troduced the heterogeneity of the prepayment cost in mortgagors’ behaviors and
presented a more comprehensive model in which mortgage holders make prepay-
ment decisions at discrete time intervals. He stated that these two features of the
model endogenously produce the burnout phenomenon.
In our model, we directly explain the burnout phenomenon of prepayment by
the heterogeneity of the mortgagors’ incentives for prepayment. In our model, note
that prepayment is exclusively grouped into four categories: (1) prepayment due to
refinancing (d = 1); (2) prepayment due to sales of houses (d = 2); (3) prepayment
due to defaults (d = 3); and (4) partial prepayment. We ignore the 4th category.
Then, prepayment is described as the time until an individual mortgagor leaves the
pool of mortgages by prepayment. Let τk be the exit time of the kth person:

τk = min{τkd : d = 1, 2, 3} ,

where τkd is the minimum time until the kth person prepays due to the dth factor.
The reasons and incentives for prepayment of individual mortgage holders in each
category are different, and so are the τk s. In general, the heterogeneity of these reas-
ons and incentives in a loan pool is not considered, because no data are available.
However, it is important to understand that it forms the main factor for the burnout
phenomenon. Thus, in this paper, we consider the phenomenon the heterogeneity
of economic incentives in the pool and model it as the heterogeneity of exit times
τk s caused by refinancing (d = 1). In our model, the heterogeneity is treated as
the differences between the boundaries (incentive thresholds) of the τk s defining
exit time in terms of the spread of the initial and current mortgage rates. As a
demonstration, we give a numerical example together with a simple interest rate
model where the prepayment activity is simulated and an MBS is priced at 0. Also,
the effect of the mean level of interest rate and the effect of the mean level of
PRICING MORTGAGE-BACKED SECURITIES (MBS) 191

thresholds on the prices of an MBS are studied and an estimation procedure for
unknown parameters in the model is described when the prepayment history up to
time n is observed.
As a general reference, we cite Fabozzi (1995) on U.S. MBSs.

2. Cashflow Function of an MBS

In this section, we describe the cashflow function of an MBS as a pass-through
security with guaranty against default. We only consider an MBS based on a fixed
rate loan with equal monthly payment by borrowers. Let Rn be the borrower’s
mortgage rate at n, C the coupon of the MBS, and S the servicing rate. All these
rates are annual rates. Also, let N be the maturity in a month, m the current month
for valuing the MBS for the remaining period when the prepayment history up to
m is given, and n a future month (0 6 m 6 n 6 N). Further, let MBn be the
remaining balance at n when no prepayment occurs. Then, as is well known, the
constant monthly payment made by all the borrowers in the pool is
R0 /12(1 + R0 /12)N
MP = MB0 × (1)
(1 + R0 /12)N − 1
and the remaining balance at n with no prepayment is
(1 + R0 /12)N − (1 + R0 /12)n
MBn = MB0 × (n = 1, . . . , N). (2)
(1 + R0 /12)N − 1
When prepayments are taken into account, the remaining balance at n is expressed
as  
R0 /12 × (1 + R0 /12)N−n+1
MPn = MBn−1 = MPn × Qn−1 , (3)
(1 + R0 /12)N−n+1 − 1
where
Qn = (1 − SMM n ) × (1 − SMM n−1 ) × . . . × (1 − SMM 1 ) (4)
is the survival (remaining) rate of the total balance, i.e., the ratio of the actual bal-
ance with prepayment and the balance without prepayment. Here, SMM n denotes
the Single Monthly Mortality at n or, equivalently, the marginal monthly mortality
rate from n − 1 to n in terms of the actual balances. Clearly by (4)
Qn−1 − Qn
SMM n = . (5)
Qn−1
The interest part in the monthly payment (3) with prepayment is
I n = MBn−1 × R0 /12 = In × Qn−1 (6)
and the principal part is
R0 /12
P n = MPn − I n = MBn−1 × = Pn × Qn−1 , (7)
(1 + R0 /12)N−n+1 − 1
192 TAKEAKI KARIYA AND MASAAKI KOBAYASHI

where In and Pn are, respectively, initially scheduled interest and principal payment
when no prepayment is assumed:
Pn = MBn−1 − MBn
R0 /12 × (1 + R0 /12)n−1 (8)
= MB0 × (n = 1, . . . , N) ,
(1 + R0 /12)N − 1

In = MBn−1 × R0 /12
R0 /12 × [(1 + R0 /12)N − (1 + R0 /12)n−1 ]
= MB0 × (9)
(1 + R0 /12)N − 1
(n = 1, . . . , N) .

Further, the prepayment amount at n is

PRn = (MBn−1 − P n ) × SMM n (10)
which is (the actual balance at n − 1 − the actual principal payment at n) × SMMn .
Now, the total cashflow of the MBS paid to investors at n is the sum of the actual
principal at n, the prepayment amount at n, and the interest with the servicing fee
deducted:
 
C
CFn = P n + PRn + × In
C +S
= Pn × Qn−1 + (MBn−1 × Qn−1 − Pn × Qn−1 ) × SMM n +
C
+ × In × Qn−1 (11)
C+S
 
C
= (Pn − MBn−1 ) × Qn + MBn−1 + × In × Qn−1
C+S
≡ an Qn + bn Qn−1 ,
where
an = Pn − MBn−1 ,
C (12)
bn = MBn−1 + × In .
C +S
Note that an and bn are known at 0 and hence the cashflow function (11) is a linear
function of Qn−1 and Qn , the survival rates at n − 1 and n.

3. Valuation Formula for an MBS

In this section, we derive a theoretical valuation formula for an MBS with het-
erogeneous prepayments. A basic assumption for doing this is that there are K
loan borrowers in the pool and the loan sizes are equal, say A0 . This assumption
PRICING MORTGAGE-BACKED SECURITIES (MBS) 193

enables us to distinguish individual behaviors associated with changes of the bal-

ance and treat the burnout phenomenon. It is also assumed that there is no partial
prepayment. Let
Ln = the number of borrowers who prepay up to n .
Then, since MBn = A0 (K − Ln ), the single monthly mortality at n is
Ln − Ln−1
SMM n = (L0 = 0) (13)
K − Ln−1
and hence the remaining rate of the principal balance at n is
Yn
Ln
Qn = (1 − SMM i ) = 1 − . (14)
i=1
K

Therefore, the n-th month cashflow in (11) is expressed as a function of the

secession rate Ln /K;
   
Ln Ln−1
CFn = an 1 − + bn 1 − , (15)
K K
where an and bn are given in (12) and are known.
In order to derive a no-arbitrage value at m of the nth cashflow, let the process
of cash be given by
 
X
n−1
Bn = exp  rj h (h = 1/12) , (16)
j =0

where {rj } is an interest rate process. Then, by a general no-arbitrage pricing theory
in a discrete time framework (see Kariya, 1997), we obtain

THEOREM 3.1 The no-arbitrage value at m of the MBS with maturity N is given
by
X
N
V (m, N) = CF(m, n) , (17)
n=m+1

where
CF(m, n) = Bm Em∗ bCF n /Bn c
(18)
= Em∗ [1(m, n)(an Qn + bn Qn−1 )] ,
 
X
n−1
1(m, n) = exp − rj h (19)
j =m
194 TAKEAKI KARIYA AND MASAAKI KOBAYASHI

and the conditional expectation Em∗ (·) at m is made with respect to a martingale
(risk neutrality) measure for {rj } and {Lj }.

Note that the martingale measure is not unique in our problem, because there
are many risk factors for {Lj }.
Let Jn−m be the number of the borrowers who will secede from the pool during
the period from the (m + 1)-th month to the nth month to get

Ln = Jn−m + Lm . (20)

Then, we obtain
   
Lm ∗ Jn−m
CF(m, n) = 1 − (an + bn )D(m, n) − an Em 1(m, n) −
K K
  (21)
∗ Jn−1−m
− bn Em 1(m, n) ,
K
where L0 = 0 and

D(m, n) = Em∗ [1(m, n)] . (22)

Therefore, to value the MBS, we need to value

(i) the discount bond D(m, n) (n = m + 1, . . . , N) and
(ii) the conditional expectation
Em∗ [1(m, n)Jn−m ] = (K − Lm )Em∗ [1(m, n)] − Em∗ [1(m, n)(K − Ln )]. (23)
To continue the evaluation of (23) a bit further, let τk be the exit (secession) time of
the kth borrower and the exit time event {τk = j } (k = 1, . . . , K; j = 1, . . . , N).
The event generation function can be defined by

1 if {τk = j }
χk,j = χ{τk =j } = .
0 otherwise
Then, clearly it holds that
1. χk,j χk,n = 0 (j 6 = n) ,
X
N
2. χk,j = 1 ,
j =1
X
n
3. for Lk,n = χk,j , Lk,n = 1 → Lk,n0 = 1 (n0 > n) ,
j =1
X
K
4. Ln = Lk,n .
k=1
PRICING MORTGAGE-BACKED SECURITIES (MBS) 195

Since Lm is given at m, say Lm = b, let these people who prepaid up to m be

k = 1, . . . , b. Then,
X
K X
K X
n
Jn−m = (Lk,n − Lk,m ) = χk,j (24)
k=b+1 k=b+1 j =m+1

and hence given Lk,m = 1 (k = 1, . . . , b), (23) can be expressed as

X
K X
K X
n
Em∗ [1(m, n)(Lk,n − Lk,m)] = Em∗ [1(m, n)χk,j ]
k=b+1 k=b+1 j =m+1
(25)
X
K
= (K − b)Em∗ [1(m, n)] − Em∗ [1(m, n)(1 − Lk,n)] .
k=b+1

This is the expression for which the heterogeneous feature of prepayments in the
pool is taken into account in the next section. In the following, we assume that
our actual measure which generates interest rates and prepayments is a martingale
measure.

4. Interest Incentive Function

In this section, we propose a model to describe the heterogeneity of the incentives
of the borrowers for refinancing. We assume for simplicity that a borrower in the
pool prepays at n for gains only when the spread of the initial mortgage rate R0
and the current rate Rn widens more than or equal to his incentive threshold. Then,
the exit (secession) time of the kth borrower is expressed as

τk = min{j : R0 − Rj > cj (k)} , (26)

where cj (k) denotes the incentive threshold of the k-th borrower at j ; this can
depend on month j . If demographic information on the k-th person is available,
we may be able to include it in the specification of cj (k). However, with Lk,n =
χ{τk 6 n} ,

Em b1 − Lk,n c = Pm (τk > n)

 
\n
(27)
= Pm  {R0 − Rj < cj (k)} ,
j =1

(25) cannot be evaluated independent of the stochastic discount factor 1(m, n).
In fact, the mortgage rate process {Rn } and the interest rate process in 1(m, n)
are highly correlated. This distinguishes the MBS prepayment model from a credit
risk model where the credit spreads of interest rates are often assumed to be inde-
pendent of the nondefaultable rates. To get a basis for the evaluation of (25), let us
196 TAKEAKI KARIYA AND MASAAKI KOBAYASHI

assume for simplicity that the mortgage rate Rn is a linear function of an sh year
(long-term) interest rate rn (sh):
Rn = α + βrn (sh) , (28)

where h = 1/12, and that rn (sh) is a linear function of the one-month spot rate rn
(affine model):

rn (sh) = γ (s) + δ(s)rn . (29)

Of course, the assumption for (28) and (29) can be replaced by a more general
set-up associated with forward rates. Under this assumption, Rn becomes

Rn = α(s) + β(s)rn , (30)

where β(s) > 0. Then,
  
Y
n
Em [(1 − Lk,n )1(m, n)] = Em  χ{ej (k)<rj }  1(m, n) , (31)
j =1

where

ej (k) = (R0 − α(s) − cj (k))/β(s) .

To get a value from this formula, we need to give a distribution of the thresholds
en (k) over borrowers k = 1, . . . , K for each n. This distribution is, in fact, directly
associated with the burnout phenomenon of prepayments in the pool. However, we
do not have sufficient knowledge of the distribution. Hence, as the most likely case,
we assume that the threshold cn (k) is constant over time n = 1, . . . , N and that
the distribution of c(k)s over k is approximated by a normal distribution. To specify
it formally, let the spread of the initial and current spot rates be
r0 − rn = un . (32)

Then,
τk = min{j : R0 − Rj > dk } = min{j : r0 − rj > dk0 } , (33)

where dk0 = dk /β(s). In this expression, the thresholds are regarded as dk s and
hence

ASSUMPTION. Let
1
pl = × {# of dk0 in [(l − 1)η, lη)} .
K
Then, pl is approximated by the area of normal distribution N(µ, σ 2 ) over
[(l − 1)η, lη) (l = 1, . . . , q).
PRICING MORTGAGE-BACKED SECURITIES (MBS) 197

Under this assumption, the K borrowers are allocated into q groups according
to the sizes of their thresholds and we get the approximation
X
K X
q
Lk,n /K ≈ gl (un )pl (34)
k=1 l=1

and hence
X
K X
q
E0 [1(0, n)Lk,n ]/K ≈ E0 [1(0, n)gl (un )]pl , (35)
k=1 l=1

where q is smaller than K and, by assumption,

p1 = 8((η − µ)/σ ) ,
p2 = 8((2η − µ)σ ) − 8((η − µ)/σ ) ,
.. (36)
.
pq−1 = 8(((q − 1)η − µ)/σ ) − 8(((q − 2)η − µ)/σ ) ,
pq = 1 − 8(((q − 1)η − µ)/σ ) .
Here, gl (un ) denotes the prepayment event of the lth group and is defined by

1 if lη 6 uj (before n) ,
gl (un ) = (37)
0 otherwise
where uj = r0 −rj and qη = ∞. The first group of borrowers prepays if the spread
goes over or is equal to η and the relative portion is p1 , the second group prepays
if the spread goes over or is equal to 2η and the portion is p2 , and so forth. Also, µ
is the average level of thresholds of borrowers responding to the spreads and σ is
chosen as µ/3 so that
qη = µ + 3σ .
For example, when q = 10 and µ = 0.02, then σ = 0.02/3 and η = 0.04/10 =
0.004. In Figure 1, the relation of the spread and the distribution of the thresholds
are drawn.

5. Monte Carlo (MC) Valuation of an MBS

In this section, we run an MC simulation to value an MBS numerically at 0. We first
describe our MC simulation procedure where a simple interest model is assumed.
Then, theoretical values of an MBS are numerically evaluated by the method.
198 TAKEAKI KARIYA AND MASAAKI KOBAYASHI

Figure 1.

5.1. MONTE CARLO ( MC ) SIMULATION METHOD

Suppose for simplicity that the monthly spot rate process {rn } follows the mean
reverting normal model (Vasicek model);
√
1rn = θ0 (θ1 − rn−1 )h + θ2 hεn (h = 1/12) ,
(38)
ε ∼ iid N(0, 1) ,
where 1rn = rn − rn−1 . For θ0 , θ1 , θ2 , and r0 given, generate I paths of N standard
normal random numbers;
(ε1(i) , ε2(i) , . . . , εN(i) ) , (39)
where i = 1, . . . , I . Each of (39) gives a path of interest rates via (38);
(r1(i) , r2(i) , . . . , rN(i) ) , (40)
which in turn gives a set of N random discount factors
 
X
n−1
(1(i) (i) (i) 
1 , 12 , . . . , 1N ) with 1n = exp −
(i)
rj(i) h . (41)
j =0

Thus, we obtain an estimate of the discount functions D(0, n)s based on I sets;

1 X (i)
I
D̂(0, n) = 1 (n = 1, . . . , N) . (42)
I i=1 n

Next, we evaluate the right side of (34). Using (37), suppose that the ith path of the
spread u(i)
n attains

vl = lη (l = 1, . . . , q) (43)
at m(i)
l for the first time, where

m(i) (i)
1 < m2 < · · · < m q .
(i)
(44)
PRICING MORTGAGE-BACKED SECURITIES (MBS) 199

If the ith path attains vq before N, that is, if m(i)

q < N, then all borrowers prepay
(i)
before maturity N. If mq > N, the remaining borrowers in the pool pay the last
remaining amount at N. Therefore, the figures we need to compute the right side
of (34) are tabulated for m(i)q > N as follows:

j 0 1 2 ··· n ··· N

εj(i) ε1(i) ε2(i) ··· εn(i) ··· εN(i)

rj(i) r0 r1(i) r2(i) ··· rn(i) ··· rN(i)
1(i)
j 1(i)
1 1(i)
2 ··· 1(i)
n ··· 1(i)
N
u(i)
j u(i)
1 u(i)
2 ··· u(i)
n ··· u(i)
N

gl (u(i)
j )

l pl j
1 2 m(i)
1 m(i)
2 N

1 p1 0 0 1 1 ··· 1 ··· 1
2 p2 0 0 0 0 ··· 1 ··· 1
.. .. .. .. .. .. ..
. . . . . . .
q pq 0 0 0 0 ··· 0 1

ξl(i) (j ) = 1(i) (i)

j gl (uj )pl

l pl j
1 2 m(i)
1 m(i)
2 N

1 p1 0 0 1(i)
m1 p1 1(i)
m1 +1 p1 · · · 1m2 p1 · · ·
(i)
1(i)
N p1
2 p2 0 0 0 0 · · · 1(i)
m2 p2 · · · 1(i)
N p2
.. .. .. .. .. ..
. . . . . .
q pq 0 0 0 0 ··· 0 · · · 1(i)
N pq

Total λ(i) (0, 1) λ(i) (0, 2) λ(i) (0, N)

Here,

ξl(i) (n) = 1(i) (i)

n gl (un )pl . (45)
200 TAKEAKI KARIYA AND MASAAKI KOBAYASHI

Hence, summing this up over l to get

X
q
λ (0, n) =
(i)
1(i) (i)
n gl (un )pl (46)
l=1

and averaging this over i, we obtain an estimate of the right side of (34);

1 X (i)
I
λ (0, n) . (47)
I i=1

Using this, we are able to value an MBS in (18) numerically.

5.2. NUMERICAL VALUATION

To value an MBS, we first describe our MBS, the interest rate model, and the
incentive function. Second, we consider the effect of changes of the mean reversion
level of interest rates on values of the MBS and the effect of changes of thresholds
on values of the MBS.
We consider a 30-year MBS with $100 face value and 6.5% coupon made
of mortgage loans with 7% rate and equal monthly payment. Here, 0.5% is the
servicing fee. Thus,
R0 = 0.07, S = 0.005, C = 0.065, and N = 360 .
In the interest rate model, put
θ0 = 0.2, θ1 = 0.05, θ2 = 0.008, h = 1/12 = 0.083, and r0 = 0.05 ,
which are, respectively, the speed of mean reversion, mean reversion level, volatil-
ity, time unit for change, and initial rate. Third, the parameters of the approximate
distribution of the thresholds are given as
q = 10, µ = 0.02, σ = 0.0067, and η = 0.004 (40 bp) .
Here, the mean level of the distribution is 2%, the standard deviation is σ = 2/3%,
and η is taken as qη = µ + 3σ . The number of the paths we generate by MC is
I = 1, 000. In this set-up, we obtained a theoretical value of the MBS as 102.1
dollars.
In Figure 2, the values of cashflows CF(0, n) with and without prepayments in
this MC evaluation are graphed. The cashflows with prepayment are valued more
up to about 80 months than those without prepayment, and they are valued less
thereafter. This is the effect of prepayment and changes the value of an MBS.
Next, let us consider the effect of the change of the mean reversion level θ1 in
the interest rate model on values of the MBS, where all other parameters are kept
unchanged. The values and the graph are given in Figure 3. Clearly, it is observed
that the greater θ1 is, the smaller the value of the MBS is. Note that the mean
PRICING MORTGAGE-BACKED SECURITIES (MBS) 201

Figure 2.

Figure 3.

reversion level θ1 is a long-term mean of interest rates and that changes in the level
have two effects on the value of the MBS. In fact, on the one hand, an increase of
θ1 will make the incentive for prepayment smaller because the spread gets smaller
on the average, which will make values of the MBS higher. On the other hand, an
increase of θ1 will make values of the MBS lower because the discount rates in the
discount function get larger. The graph shows that the latter effect is much larger
than the former.
Now, we can consider the effect of changes of the mean µ of thresholds on
values of the MBS. Our MC result on this effect is given in Figure 4. From the
figure, it can be observed that the smaller µ is, the lower the value of the MBS is.
When µ gets larger, the speed of the increase of the value decreases even though
the value increases. Prepayments occur less when µ gets larger and the value of the
MBS will approach the value with no prepayment.
Finally, we consider the case where the group number q changes. Figure 5 sum-
marizes this case. When q is larger, the thresholds for the heterogeneous incentives
202 TAKEAKI KARIYA AND MASAAKI KOBAYASHI

Figure 4.

Figure 5.

of borrowers are more divided and hence the MBS will be more accurately valued.
But, as the graph shows, the values do not change much after q = 20.

6. Estimation Procedure
So far, we have considered the theoretical price at 0 of an MBS. In this section,
we describe the valuation method at m when the prepayment history of the pool
is given together with the history of interest rates up to m. Given the two last
sequences, the unknown parameters in the incentive function are estimated by the
least squares (LS) method that minimizes the squared sum of the differences of
actual and model prepayments.
To describe the method, we first note that SMMs are observable. This informa-
tion is converted into the secession rates AMMn = Ln /Ks;
Ln − Ln−1 Ln /K − Ln−1 /K
SMM n = =
K − Ln−1 1 − Ln−1 /K
(48)
AMM n − AMM n−1
= .
1 − AMM n−1
PRICING MORTGAGE-BACKED SECURITIES (MBS) 203

Then, from AMM 0 = L0 /K = 0, we obtain the recursion formula

AMM n = AMMn−1 + SMM n (1 − AMMn−1 ) , (49)

where n = 1, 2, . . . , N. Now, suppose that (AMMj , uj ) with uj = r0 − rj are

observed for j = 1, . . . , m. Then, we estimate the group number q, threshold unit
η, threshold mean µ, and standard deviation σ using the LS method. Define the
objective function to be minimized by
" #2
Xm X q
9(q, η, µ, σ ) = AMM j − gl (uj )pl
j =1 l=1
m 
X  
lj η − µ 2 (50)
= AMM j − 8
j =1
σ
   
lj η − µ
if lj = q, 8 = 1. See (36). ,
σ
where

lj = max{l ∗ ∈ N : l ∗ η 6 uk , k = 1, . . . , j } .

Then, the objective function should be minimized under the restrictions

η > 0, µ > 0 and σ > 0 . (51)

To carry this out, for each q we minimize 9 with respect to η, µ, and σ , where η
is assumed to take a certain finite number of values ηi s in [0, η∗ ]. For example, set
η∗ = 0.02 and ηi = iη∗ /100. Also, q is assumed to change over q = 10, . . . , 30,
from which we find (q, η, µ, σ ) minimizing (50).
Once the parameters are estimated, the price of an MBS at m is valued through
(17) in the same way as discussed in Sections 4 and 5.

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