Woodhead Behavior and the Pricing of Residential Mortgages

Mortgage terminations arise because borrowers exercise options. Empirically the extent to which the call is in the money is strongly associated with exercise of the prepayment option, and the probability that the put option is in the money is strongly associated with exercise of the default option. Nevertheless, evidence also shows that borrowers do not behave as “ruthlessly ” as the theory predicts. This paper investigates the apparently irrational behavior of those borrowers who do not terminate their mortgages even when the option is deeply into the money. We develop an option-based empirical model to analyze this phenomenon-- the behavior of irrational “woodheads. ” Of course we do not observe “woodheads” explicitly in any body of data. Instead, we analyze the correlates of unobserved heterogeneity within a large sample of mortgage holders. We extend SMLE techniques proposed by Stinebrickner (1999) to estimate the competing risks of mortgage prepayment and default, recognizing unobserved heterogeneity, which is due in part to the behavior of “woodheads. ” The extended model is clearly superior to alternatives o