To Sell or To Retain: Interest Rate Risk in Fixed-Rate Mortgages and Banks' Securitization Decisions

56 Pages Posted:

See all articles by Zhanbing Xiao

Zhanbing Xiao

The University of British Columbia

Date Written: December 1, 2020

Abstract

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

Xiao, Zhanbing, To Sell or To Retain: Interest Rate Risk in Fixed-Rate Mortgages and Banks' Securitization Decisions (December 1, 2020). Available at SSRN: https://ssrn.com/abstract=

Zhanbing Xiao (Contact Author)

The University of British Columbia ( email )

Vancouver, British Columbia
Canada

HOME PAGE: http://www.zhanbingxiao.com

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
22
Abstract Views
132
PlumX Metrics