A Theory of the Mortgage Rate Pass-Through

We present an analytically tractable model of the mortgage-rate pass through and the cross- section 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. We present two versions: (1) Rational attentive investors facing small adjustment cost refinance as soon as the current mortgage rate is below their individual mortgage rate; (2) 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 ergodic distribution of mortgage rates and short-rates in the economy. The mortgage rate function m(r) is non- linear for low levels of the short-rate. 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, the mortgage pass-through is affected by default risk, financial literacy, and the competitiveness of the banking industry.