Working Paper: NBER ID: w0725
Authors: Patric Hendershott; Kevin E. Villani
Abstract: This paper examines the portfolio choice of savings and loan associations (SLAS) between mortgages and bonds, first in a certainty world and then under uncertainty. Differences in servicing and transactions costs, in default losses, in tax treatment and in the timing of payments are accounted for in a certain world. SLAs are seen as investing in bonds only if the demand for mortgage funds is sufficiently weak that more profitable SLAs compete away some of the value of their tax preference by bidding down mortgage rates; in this case less profitable SLAs would find corporate debt attractive. In an uncertain world, mortgages will command a premium over bonds to compensate for the prepayment option extended mortgage borrowers. The appropriate value of this premium depends on uncertainty regarding future interest rates and aversion to this uncertainty. SLAs that view future interest rates as more uncertain than the market does generally, or who are more averse to this uncertainty, will require an options premium greater than that determined in the market. Thus they will find corporate debt to be attractive relative to bonds, even when the demand for mortgage funds is strong and their mortgage tax preference is not competed away.
Keywords: Savings and Loan Associations; Corporate Debt; Investment Decisions; Deregulation
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Weak demand for mortgage funds (G21) | SLAs invest in bonds (G12) |
| Uncertainty (D89) | Mortgages command a premium over bonds (G21) |
| Perception of future interest rates as uncertain (E43) | SLAs require a larger options premium (G19) |
| Larger options premium (G13) | SLAs prefer corporate debt over bonds (H74) |
| Cost advantages in underwriting mortgages (G21) | SLAs' investment strategies (G11) |