Interest rate risk, prepayment risk, and banks’ securitization of mortgages!

Unlike traditional banks that accustomed to hold loans until they matured or were compensated off, modern banks choose to combine assets into pools then sell these to market investors through securitization. This is whats called the increasing adoption from the originate-to-distribute model within the banking sector. Within the mortgage market, banks’ securitization ratio has elevated from about 30% in 1994 to greater than 50% in 2017 (see figure 1 for that trend).

Figure 1: Banks’ Mortgage Securitization within the U . s . States

Line chart showing Figure 1: Banks’ Mortgage Securitization within the U . s . States

It’s broadly thought that this rising securitization trend was an essential driver from the 2008 global financial trouble. Meanwhile, across banks in almost any given year, there’s a large dispersion of securitization activities. A fascinating but understudied real question is what drives the dispersion. Existing literature studying this mostly concentrates on default risk in mortgages. Inside a new paper, I provide a new position by analyzing the eye rate risk and prepayment risk in mortgages.1

The important thing argument within this paper is the fact that retaining or securitizing a home loan depends upon a bank’s ability to accept rate of interest risk within the mortgage. This ability is dependent upon the maturity of the bank’s liabilities. Particularly, banks with longer-maturity liabilities tend to be more able to take the eye rate risk in mortgages. The essential logic behind this really is maturity matching. Banks match the maturities of the liabilities using the maturities of the asset holdings to make sure that the general exposure of the internet interest earnings to fluctuations of great interest rates is at an acceptable range. This really is very essential for banks’ risk management, thinking about their limited utilization of rate of interest derivatives to hedge the danger.

I appraise the maturity of the bank’s liability while using interest expense beta suggested by Drechsler,

Savov, and Schnabl (2021). This interest expense beta reflects the sensitivity of the bank’s interest expenses to alterations in the government funds rate. The greater the beta is, the greater the sensitivity of the bank’s liability to rates of interest is, implying the liabilities of low-beta banks act like lengthy-term and glued-rate debt. Consequently, low-beta banks have longer maturities in liabilities.

My empirical results reveal that within the conforming mortgage market,2 banks with longer-maturity liabilities retain more mortgages, while banks with short-maturity liabilities securitize more mortgages (see figure 2 for any visual presentation from the results). A 1 standard deviation rise in maturity is connected having a 5.09% rise in mortgage securitization. This is reflected in banks’ balance sheets-banks with maturity one standard deviation over the average hold 7.3% more residential property loans on their own balance sheets.

Figure 2: Maturities of Banks’ Liabilities and Mortgage Securitization

Line chart showing Figure 2: Maturities of Banks’ Liabilities and Mortgage Securitization

Additionally, for jumbo mortgages that can’t be securitized with the government-backed enterprises-Fannie Mae and Freddie Mac, that are dominant players within the securitization market-banks with shorter-maturity liabilities have a lower approval rate. It is because the restriction on securitizing jumbo mortgages forces banks with short-maturity liabilities to consider an excessive amount of rate of interest risk. To avert this, banks with short-maturity liabilities approve less jumbo mortgages ex ante.

However, holding mortgages on balance sheets exposes banks to prepayment risk. This risk can also be very prominent within the U.S. market, because of the insufficient prepayment penalties. The prepayment risk matters more for banks with longer-maturity liabilities, because they hold more mortgages on balance sheets. I reveal that these banks steer clear of the prepayment risk in 2 ways. First, ex ante, anticipating the danger, they securitize more mortgages. By doing this, they transfer the prepayment risk with other market investors. Second, ex publish, they steer clear of the risk through less resources of refinancing options, that’s, rejecting household refinancing demands or making the financial lending options less attractive. This directly prohibits households from having to pay mortgages before maturity.

Policy Implications

Analyzing banks’ securitization decisions enables comprehending the much deeper the main from the 2008 global financial trouble, which will help regulators better monitor banks’ high risk within the mortgage market. This paper emphasizes that rate of interest risk and prepayment risk are equally as essential as default risk in explaining banks’ mortgage securitization activities. Thinking about the limited financial and human sources of bank regulators, using the maturities of banks’ liabilities into account during inspections can be a more effective method to regulate the mortgage market if this becomes hot.

Reference:

Drechsler, I., Savov, A. and Schnabl, P., 2021. Banking on deposits: Maturity transformation without rate of interest risk. Journal of Finance, 76(3), pp.1091-1143.

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