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The Financial Express

Banks' securitisation of mortgages: interest rate & prepayment risks


Banks' securitisation of mortgages: interest rate & prepayment risks

Unlike traditional banks that used to hold loans until they matured or were paid off, modern banks prefer to combine assets into pools and sell them to market investors through securitisation. This is known as the rising adoption of the originate-to-distribute model in the banking sector. In the mortgage market, banks' securitisation ratio has increased from about 30 per cent in 1994 to more than 50 per cent in 2017 (see figure 1 for the trend).

It is widely believed that this rising securitisation trend was an important driver of the 2008 global financial crisis. Meanwhile, across banks in any given year, there exists a large dispersion of securitisation 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, this writer offers a new angle by examining the interest rate risk and prepayment risk in mortgages. Interest rate risk refers to the risk that a change in market interest rates leads to an opposite change in the value of a mortgage. Prepayment risk refers to the risk that the outstanding amount of a mortgage is prematurely paid back.

The key argument in this paper is that retaining or securitising 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.

The writer measures 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.

The author's empirical results show that in the conforming mortgage market, banks with longer-maturity liabilities retain more mortgages, while banks with short-maturity liabilities securities more mortgages. Conforming mortgages refer to mortgages whose amounts are below the conforming loan limit. Mortgages whose amounts are above the conforming loan limit are called jumbo mortgages. A one standard deviation increase in maturity is associated with a 5.09 per cent increase in mortgage securitisation. This is also reflected in banks' balance sheets-banks with maturity one standard deviation above the average hold 7.3 per cent more residential real estate loans on their balance sheets.

In addition, for jumbo mortgages that cannot be securitised through the government-sponsored enterprises-Fannie Mae and Freddie Mac, which are dominant players in the securitisation market-banks with shorter-maturity liabilities have a much lower approval rate. This is because the restriction on securitising jumbo mortgages forces banks with short-maturity liabilities to take too much interest rate risk. To avoid this, banks with short-maturity liabilities approve fewer jumbo mortgages ex ante.

However, holding mortgages on balance sheets exposes banks to prepayment risk. This risk is also very prominent in the U.S. market, due to the lack of prepayment penalties. The prepayment risk matters more for banks with longer-maturity liabilities, as they hold more mortgages on balance sheets. The author of the paper shows that these banks avoid the prepayment risk in two ways. First, ex ante, anticipating the risk, they securitize more mortgages. In doing this, they transfer the prepayment risk to other market investors. Second, ex post, they avoid the risk through fewer supplies of refinancing options, that is, rejecting household refinancing requests or making the financing options less attractive. This directly prohibits households from paying mortgages before maturity.

POLICY IMPLICATIONS: Analysing banks' securitisation decisions enables understanding the deeper the root of the 2008 global financial crisis, which helps regulators better monitor banks' risk taking in the mortgage market. This paper emphasises that interest rate risk and prepayment risk are equally as important as default risk in explaining banks' mortgage securitisation activities.  Considering the limited financial and human resources of bank regulators, taking the maturities of banks' liabilities into consideration during inspections may be a more efficient way to regulate the mortgage market when it becomes too hot.

 

The piece is excerpted from www.blogs.worldbank.org

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