Mortgage structures have varying impacts on the fortunes of lending banks and the stability of the financial sector, depending upon whether the mortgage interest rate is fixed or adjustable, and the duration of the fixation length, in different macroeconomic settings, according to a new paper by Wharton finance professor Lu Liu and Vadim Elenev, a professor at Johns Hopkins University’s Carey Business School.

The paper, titled “Mortgage Structure, Financial Stability, and Risk Sharing,” modeled mortgage structures with elements including flexible mortgage contracts, default risks, and sticky bank deposits to evaluate the impact of interest rate changes on financial stability.

“In the most recent interest-rate tightening cycle, there has been a common, global rise in rates, but it has had very different ramifications in terms of macroeconomic and financial stability outcomes, depending on the mortgage structure,” said Liu.

The authors set their study against the backdrop of contrasting risks between adjustable-rate mortgages (ARMs) and fixed-rate mortgages (FRMs): ARMs expose households to rising rates, increasing default risk through higher payments. FRMs protect households with predictability in interest payments, but they potentially expose banks to greater interest rate risks.

Liu pointed out that the 30-year FRMs that are common in the U.S. protect households from interest-rate increases, but rate increases also lower the market value of the underlying assets, which could translate into financial stability risks for banks.

In Canada and Europe where ARMs and shorter fixation lengths are common, households take a direct hit from rising interest rates, which in turn increases the risk of defaults. But that does not necessarily translate into stress for banks because they earn higher income from rising interest rates, which serves as a cushion against defaults.

The paper noted that FRMs benefit from deposit rate stickiness, which reduces volatility, whereas ARMs allow banks to hedge risks, concentrating defaults when their net worth is high, thus lowering risk premia.

Optimal Mortgage Design

Given those different outcomes, the challenge for the model was to find the right mortgage structure to ensure the stability of the financial sector. The solution was to design mortgages with an “intermediate fixation length” with a duration of between three and five years, which balanced the positive and negative effects of ARMs and FRMs, minimizes banking sector volatility and improves aggregate risk-sharing.

The model could also explain differences in delinquencies, house prices, and bank equity prices in countries that had either ARMs or FRMs as the dominant mortgage structure during 2022-2023.

“Our model provides a framework for understanding how changes in policy rates affect financial stability differentially across mortgage structures.”— Lu Liu

Pros and Cons of ARMs and FRMs

Volatility in interest income is a reality with ARM structures. When interest rates fall, banks earn lower profits. But when interest rates rise, they translate into higher interest income for banks. But the interest rates banks pay on deposits don’t increase proportionately, which means they earn higher profits and are able to strengthen their capital base, Liu explained.

Conversely, banks make smaller profits when interest rates drop. “So, if you’re a bank and you issue fully adjustable-rate mortgages, your income will be very volatile, depending on where interest rates go,” Liu said.

With FRM portfolios, banks don’t face volatility in interest income because deposits tend to be sticky, and they are less sensitive to interest rate changes, she continued. Also, when deposits are sticky, banks would prefer longer-duration assets.

Liu also pointed to tradeoffs for banks with either ARMs or FRMs in a rising interest rate environment: ARMs enable banks to hedge the risk of defaults as rates rise; the higher interest income offsets the impact of the higher incidence of defaults. Liu’s datasets showed that as interest rates rose, banks in the U.K. with ARMs outperformed U.S. banks.

On the other hand, when interest rates rise, FRM portfolios will see an erosion in the value of their mortgages because they earn lesser income than the rest of the market.

The Best of Both Worlds

Clearly, both FRMs and ARMs have both advantages and disadvantages, Liu noted. It is that setting which made way for the paper’s innovative option of an intermediate mortgage structure. Such a mortgage is fixed for a relatively shorter period of between three and five years. “We find that these contracts provide the best overall financial stability properties,” she added. From the standpoint of financial stability, the volatility of the financial system is minimized at three years, and risk sharing across households is optimized at five years.

Macroeconomic correlations also influence the impact of mortgage structures on financial stability, Liu noted. For instance, interest rates typically fall when the macro economy isn’t doing too well, or if there is a recession, when household incomes also fall. In that setting, FRMs provide banks a hedge against defaults, Liu pointed out.

“When rates go up, the opportunity cost of defaulting also goes up because in defaulting, households would be giving up a mortgage with a low rate,” she explained. That also helps explain the “mortgage lock-in” phenomenon that occurs when rates are high.

However, this need not always be the case. In an environment with supply-driven shocks, rates and incomes are negatively correlated, making FRMs less attractive.

Takeaways From the Paper

Liu said her paper isn’t necessarily prescribing a policy path for the U.S. in designing mortgages. But it aims to show that different mortgage structures, such as in the U.S. and European countries, can lead to very different financial stability outcomes. Each design offers unique benefits and disadvantages, which is important for informing policymakers and potential reforms going forward, she added.

The present time is also opportune to revisit U.S. mortgage structures because any heightened inflation risk also increases interest rate risk. “There is certainly a chance that the central bank may have to increase rates even further,” Liu said. “Our findings are even more relevant now because they help you understand how the financial system may respond to higher rates.”

“Overall, our findings have implications for monetary policy and macroprudential regulation,” Liu continued. “Our model provides a framework for understanding how changes in policy rates affect financial stability differentially across mortgage structures. Our paper informs optimal mortgage design that aims to improve financial stability and risk-sharing between households and financial intermediaries.”