AN EMPIRICAL TEST OF ALTERNATIVE THEORIES OF MORTGAGE PRICING (FINANCIAL INSTITUTIONS, ADJUSTABLE RATE LOANS, SECURITY PRICING, LOAN MARKET EFFICIENCY, TERM STRUCTURE RISK)

The purpose of this dissertation is to examine the ex ante behavior of an important class of investors (financial institutions) in pricing securities (mortgage loans) included in their asset portfolios. The study develops a descriptive model for yields on mortgage instruments as a function of the risk free rate of interest, interest rate risk, and default risk. This model permits testing normative mortgage pricing approaches. The risk shifting approach suggests that given the opportunity to issue mortgages with adjustable rates the institution will shift interest rate risk to the borrower. The normal profits approach infers that the pricing of mortgage loans is determined individually by different types of institutions based on cost of funds and portfolio structures.; The basis for the descriptive model is the bond pricing study by Lawrence Fisher (1959)--also the basis for studies by Jung (1962), Page (1964), and Sandor and Sosin (1975). This study uses a paradigm wherein the institution chooses between a risky mortgage and a default free alternative. It incorporates the risk inherent in unanticipated future interest rate movements as well as the likelihood of borrower default.; This research evaluates the contributions of two normative approaches to mortgage pricing--risk shifting and normal profits; however, the major conclusion of this three part study is that mortgage bid rates are set efficiently in the financial markets. The principal pricing attributes of the loans are their risk characteristics. Contrary to the normal profits approach, lenders behave according to models of competitive pricing behavior. Moreover, the pricing of adjustable rate loans with different adjustment periods appear as individual decisions showing little evidence of yield curve tradeoffs, such as may be suggested under a motive of risk shifting.