Authors: Wayne Passmore
September 24, 2003
Publication:
Fannie Mae Foundation

Using a model of a profit-maximizing bank, the costs of funding a mortgage with deposits are decomposed into the costs associated with interest-rate-risk hedging, prepayment, credit risks, and deposit collection. Funding mortgages with retail deposits is a successful strategy if using retail deposits lowers the costs of hedging against interest rate risks. The research reported in this article, however, indicates no significant hedging cost advantage from using retail deposits. Indeed, the costs of collecting retail deposits combined with the regulatory capital requirements for banks make mortgage lending an unprofitable activity for many banks. However, profits can be increased by securitizing mortgages and by not expanding mortgage lending beyond available retail funds.

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