Mortgage Structure, Financial Stability, and Risk Sharing

Abstract

Adjustable-rate mortgages (ARMs) expose households to rising payments, increasing defaults, while fixed-rate mortgages (FRMs) expose lenders to greater interest rate risk. We evaluate these competing forces in a quantitative model with flexible mortgage contracts, liquidity-driven household default, and a banking sector with sticky deposits. We find financial stability risks are U-shaped in mortgage fixation length. While FRMs benefit from deposit rate stickiness, ARMs provide net worth hedging by concentrating defaults in states when intermediary net worth is high due to increases in mortgage income. An intermediate fixation length balances these effects, minimizing financial sector volatility and improving aggregate risk sharing.

Keywords: mortgages, financial stability, interest rate risk, credit risk, fixed-rate, adjustable-rate, risk sharing, intermediary asset pricing, household finance