Since its inception in the 1970s, the mortgage-backed security market has experienced dramatic growth in the United States. As of June 30, 2002, the total notional amount of Agency mortgage-backed securities and collateralized mortgage obligations outstanding was more than $3.9 trillion. This means that the size of these markets now exceeds the $3.5 trillion notional amount of publicly-traded U.S. Treasury debt.

Despite the importance of these markets, however, the goal of developing a fundamental theory of mortgage valuation represents an ongoing challenge to researchers. The key element that has proven difficult to explain within a rational model is how mortgage borrowers choose to refinance their loans. Influential early work by Dunn and McConnell (1981a, b), Brennan and Schwartz (1985), and others applies contingent claims techniques to the problem by modeling prepayment as an endogenous decision made by the borrower in minimizing the present value of his current mortgage. More recently, Dunn and Spatt (1986) and Stanton and Wallace (1998) extend this classical approach in an important way by modeling the prepayment decision as the result of the borrower minimizing his lifetime mortgage costs. As discussed by Schwartz and Torous (1989, 1992, 1993), however, actual prepayment behavior appears very suboptimal relative to the optimal behavior implied by these models. Furthermore, these models all have the property that mortgage-backed security prices cannot exceed par plus the number of points paid to refinance the loan. As demonstrated by Stanto (1995), Boudoukh, Whitelaw, Richardson, and Stanton (1997), and others, this upper bound is nearly always violated in practice.