This paper estimates a coefficient of substitution between fixed-rate mortgages (FRMs) and adjustable rate mortgages (ARMs), exploiting a discontinuity in legal rules governing the secondary market purchases of Fannie Mae and Freddie Mac. It is found that consumer choice between these mortgage types is strikingly priced sensitive: a 20 basis point increase in retail FRM interest rates reduces the FRM market share by 17 percentage points, holding the yield curve and other macroeconomic factors constant. Based on this coefficient, it is calculated that around half of the high FRM share in the US relative to the UK can be accounted for as a consumer response to differences in retail mortgage interest rates.

Home mortgage debt represents a large and growing share of US consumer balance sheets. As of March 2007, US households owed 9.8 trillion dollars in loans secured by residential dwellings, making up 73 percent of consumer liabilities outstanding (source: Flow of Funds). The majority of US mortgages are long-term fixed-rate contracts prepayable at little or no cost, a contract popular in few countries outside the United States. Home mortgages in other Anglo-Saxon countries such as the UK, Canada and Australia are generally closely tied to short-term interest rates. Fixed-rate contracts are more common in continental Europe and Japan, however they generally involve significant prepayment penalties and shorter repricing periods than in the US (Green and Wachter, 2005; European Mortgage Federation, 2006). The popularity of prepayable FRMs in the US has significant implications for consumer portfolios, bank balance sheets and the transmission of monetary policy. The effect on monetary transmission is asymmetric due to the nature of the prepayment option. Overall a high share of FRMs is thought to dampen monetary transmission (IMF, 2004; Miles, 2004), although FRM refinancing is estimated to significantly stimulate consumption during periods of falling long term interest rates (Hurst and Stafford, 2004). From a lender’s perspective, FRMs generate significant interest rate and prepayment risk, stimulating growth in secondary mortgage-backed securities (MBS) markets to help diversify these risks. In the UK, the high level of adjustable-rate mortgage debt is considered to be a key impediment to the adoption of a common European currency, since it implies that UK consumption is sensitive to short-term interest rates relative to Euro-zone member countries (UK Treasury, 2003; Miles, 2004).