To Sell or To Retain: Interest Rate Risk in Fixed-Rate Mortgages and Banks' Securitization Decisions
56 Pages Posted:
Date Written: December 1, 2020
The interest rate risk embedded in 30-year fixed-rate mortgages (FRMs) leads to a decline in the value of a mortgage when the market interest rate goes up. In this paper, I show that banks' abilities to absorb the interest rate risk in FRMs depends on interest sensitivities of their liabilities. Specifically, banks with interest-insensitive liabilities are more able to absorb the interest rate risk in FRMs and therefore transfer less such risk to market investors – less mortgage securitization and more retained on the balance sheet. This is because the liabilities of such banks are similar to fixed-rate and long-term debt, thereby enabling them to tolerate losses incurred by rising interest rates. Meanwhile, holding mortgages helps these banks hedge the risk of interest rates going down. Besides, I show that the prepayment risk induced by household mortgage refinancing in low-interest-rate periods increases interest-insensitive banks' incentives to securitize mortgages. Furthermore, I show that interest-insensitive banks are less willing to supply refinancing mortgages to households. Last, I show that counties dominated by interest-insensitive banks experience a much faster growth rate in house prices. Overall, my findings suggest that the interest rate risk in mortgages has important implications for banks' decisions in the mortgage market.
Keywords: Banks, Deposits, Interest Rate Risk, Mortgage Securitization, Mortgage Refinancing, House Price
JEL Classification: E43, E50, G21, R20, R31
Suggested Citation: Suggested Citation