Unwilling to take on interest rate risk, banks often make borrowers finance operations with variable-rate debt.
With the advent of securitization, or the ability to package up mortgages and sell them off as securities, the market found some investors — bond funds, insurance companies and others — that were willing to take on interest-rate risk.
The banks were happy to receive one-fourth of one percent interest risk-free on idle excess reserves.
A similar area of vulnerability in America may be in credit unions, a type of financial co-operative, which have also taken on interest-rate risk through fixed-rate lending funded by variable-rate deposits.Interest margins change relatively slowly.
Dwight Jaffee, a professor of finance and real estate at the University of California at Berkeley who has studied mortgage markets for 35 years and who wrote a paper last year on interest-rate risk at Freddie Mac and Fannie Mae, said the Sonic Capital analysis appeared to be "exactly right".
With inflation forecast to be two and a half per cent next year, imposing a lower inflation target - as some have suggested - would mean upward pressure on interest rates and risk lower growth and higher unemployment.
This chapter presents a discussion on interest and credit risk modeling.
Banks are not eager to take on the interest rate risk inherent in a traditional 30-year mortgage loan that has no prepayment penalty.
With deflation on the horizon, zero-bound on interest rates implies the risk of a liquidity trap where money and bonds become perfectly substitutable, where real interest rates become high and rising, thus further pushing down aggregate demand, and where money market fund returns cannot even cover their management costs.
But the commission says there is not enough private capital willing to take on both the interest rate risk and the credit risk of homeowners defaulting.
