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Optimal Recursive Refinancing and the Valuation of Mortgage-Backed Securities (Longstaff)

The optimal recursive refinancing problem where a borrower minimizes
his lifetime mortgage costs by repeatedly refinancing when rates
drop. Key factors affecting the optimal decision are the cost of
refinancing and the possibility that the mortgagor may have to
refinance at a premium rate because of his credit.

The optimal recursive strategy often results in prepayment being
delayed significantly relative to traditional models. Furthermore,
mortgage values can exceed par by much more than the cost of
refinancing. Applying the recursive model to an extensive sample of
mortgage-backed security prices, we find that the implied credit
spreads that match these prices closely parallel borrowers’ actual
spreads at the origination of the mortgage. These results suggest
that optimal recursive models may provide a promising alternative
to the reduced-form prepayment models widely used in practice.

Francis A. Longstaff, Anderson School of Management.

Francis A. Longstaff, "Optimal Recursive Refinancing and the Valuation
of Mortgage-Backed Securities" (December 1, 2002). Finance. Paper 15-02.

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