Banking

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

It is widely believed that this rising securitization trend was an important driver of the 2008 global financial crisis. Meanwhile, across banks in any given year, there exists a large dispersion of securitization activities. An interesting but understudied question is what drives the dispersion. Existing literature studying this question mostly focuses on default risk in mortgages. In a new paper, I offer a new angle by examining the interest rate risk and prepayment risk in mortgages.1

The key argument in this paper is that retaining or securitizing a mortgage depends on a bank’s ability to take the interest rate risk in the mortgage. This ability is determined by the maturity of a bank’s liabilities. In particular, banks with longer-maturity liabilities are more capable of taking the interest rate risk in mortgages. The fundamental logic behind this is maturity matching. Banks match the maturities of their liabilities with the maturities of their asset holdings to ensure that the overall exposure of their net interest income to fluctuations of interest rates is within a reasonable range. This is extremely important for banks’ risk management, considering their limited use of interest rate derivatives to hedge the risk.

I measure the maturity of a bank’s liability using the interest expense beta proposed by Drechsler,

Savov, and Schnabl (2021). This interest expense beta reflects the sensitivity of a bank’s interest expenses to changes in the federal funds rate. The higher the beta is, the higher the sensitivity of a bank’s liability to interest rates is, implying that the liabilities of low-beta banks are similar to long-term and fixed-rate debt. Consequently, low-beta banks have longer maturities in liabilities.

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My empirical results show that in 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 a visual presentation of the results). A one standard deviation increase in maturity is associated with a 5.09% increase in mortgage securitization. This is also reflected in banks’ balance sheets—banks with maturity one standard deviation above the average hold 7.3% more residential real estate loans on their balance sheets.

Figure 2: Maturities of Banks’ Liabilities and Mortgage Securitization

Source : blogs.worldbank.org

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