Banks typically loan 30 year home loans? How does this come to play with liabitiies? Longer-Term?
although banks lend 30 year mortgages, they are often in five year terms with prepayment options embedded etc. how does this come to play with liabilities - great question. my guess - thinking out loud, would they match the 5 year mortgages that roll over until 30 years or would they match it with a liability that has a duration of 20-25 years?
Ever even hear of someone walking into a bank to buy a 25 year CD? (30-year mortgages have durations less than 25 years anyway).
most regional banks that are not sophisticated with use of derivatives manage their b/s via asset -liability management … ie match cash flows of assets and liabilities, hence issues of duration and the effect of the prepayment options will play a part in this risk minimization process.
Actually, banks used to issue long term CDs, in the 20-30 year range. They stopped because of the early 80’s when people locked in interest rates of 15-17%. Longer term, it was too much risk (and too costly) for a bank to loan out for that long. Borrowers have the prepayment/refinance option if interest rates decline, but lenders stuck in CDs are exactly that - stuck. A major bank was a former audit client of mine, and they still had on their books a handful of senior citizens who were fortunate enough to lock in long term CDs with interest rates north of 15% from long ago. Many years later, they were still earning that rate!
I remember. Then we developed things like securitization of mortgages, financial futures, interest rate swaps, etc. and the world changed.
Yeah guys, there is indeed a maturity mismatch for most banks on such long term loans. The bank hedged the same through any of the following: (i) Keep such long term loans to a certain percentage of the balance sheet only (ii) Use Tier 1 & 2 capital to fund these long term loans, while the other liabilities fund the shorter tenor assets.