A Theory of the Mortgage Rate Pass-Through (joint with David Berger and Fabrice Tourre)

Abstract:

We present an analytically tractable model of the mortgage-rate pass through and the crosssection of coupon rates in the economy. Competitive banks offer downward adjustable fixed-rate risk-free mortgages (“refinancing”) with current mortgage rate m(r) where r is the prevailing short-rate the bank uses to finance the mortgage. Rational inattentive consumers facing small adjustment cost refinance as soon as they become aware of the current mortgage rate being below their individual mortgage rate. We analytically derive m(r) for general processes and the conditions for the ergodic distribution of mortgage rates and short-rates in the economy. The mortgage rate function m(r) is non-linear due to mean-reversion and the one-sided refinancing option. Thus, monetary policy has a differential impact on the housing market depending on the level of the interest rate r and the cross-sectional distribution of mortgage rates. Further, we model non-competitive banks posting oligopolistic quotes, and how this reduces mortgage rate pass-though. Lastly, we can easily incorporate default risk into the framework.