New on FinoLib · Volume I: Global Economy
My latest article is now live on FinoLib, the free finance library I write: Types of Financial Risk: Four Kinds and How Mortgage Lending Works, from Volume I: Global Economy. Read the summary below for the substance of the topic, then continue to FinoLib for the complete treatment.
8.4 Mortgage Lending — How a House Purchase Connects to the Whole System
The idea in plain words
A mortgage runs through origination, closing, post-closing and servicing. A US 30-year fixed rate is priced off the 10-year Treasury yield, not set by the Fed directly.
Key points
■The average 30-year fixed rate in Freddie Mac’s weekly survey rose from 3.22% on January 6, 2022, to 7.79% on October 26, 2023.
■On a $300,000 loan the monthly payment went from $1,300.68 to $2,157.54, an extra $856.86, while existing fixed-rate borrowers paid nothing extra.
A closer look
A mortgage is a loan secured by the property being purchased — the lender holds a legal claim on the property and can sell it to recover the debt if the borrower fails to repay. Mortgages are among the most common financial products in the world, and they sit at the intersection of household finance, banking, capital markets, and central bank policy in a way that makes them uniquely important for understanding how the financial system connects to everyday life.
Recap
A mortgage runs through origination, closing, post-closing and servicing. A US 30-year fixed rate is priced off the 10-year Treasury yield, not set by the Fed directly: the survey rate rose from 3.22% to 7.79% between January 2022 and October 2023, adding $856.86 a month on a $300,000 loan, while existing fixed-rate borrowers paid nothing extra.
8.5 Risk Management and Compliance in Practice
The idea in plain words
Risk management, compliance and internal audit form the Three Lines of Defense, independent of the business lines they oversee and of each other.
Key points
■Maker-checker, where one person prepares and an independent second person approves every critical action, is the everyday form of segregation of duties.
■Barings collapsed in 1995 partly because one trader, Nick Leeson, controlled both his trading and the back-office records meant to check him.
A closer look
The three control functions — risk management, compliance, and internal audit — are distinct and must remain independent of each other and of the business lines they oversee to be effective. Each provides a different kind of assurance; together they form the institutional safeguard against the failures that, when they occur at scale, become the crises covered in Sections 3.8 and 3.9.
Recap
Risk management, compliance and internal audit form the Three Lines of Defense, independent of the business and of each other. Maker-checker, one person preparing and an independent second person approving every critical action, is the everyday form of segregation of duties. The CASS Officer is a personally accountable, named regulatory role — not a team function.
8.6 The Four Types of Financial Risk
The idea in plain words
Risk teams work with four types of risk: market, credit, liquidity and operational, each with its own tools. Systemic crises, 2008 above all, are several types failing at once.
Key points
■Market risk is managed with VaR and stress tests, credit risk with collateral and limits, liquidity risk with LCR and funding lines, and operational risk with controls and reconciliation.
■The 2008 crisis involved credit risk (mortgage defaults), market risk (MBS value collapse), liquidity risk (interbank funding freeze) and operational risk (systems and teams overwhelmed) all at once.
A closer look
Risk management teams do not manage one generic category of risk. They organize their work around four distinct, well-defined types — each requiring different expertise, different measurement tools, and different management approaches. Most financial failures can be traced to one or more of these four types going unmanaged, mismanaged, or deliberately ignored.
A worked example
Worked Example — One Number for Each Risk (Illustrative)
A bank holds a $50m trading position with 1.2% daily volatility, a $20m loan, $12bn of liquid assets against $10bn of 30-day net outflows, and a payments process that fails about 25 times a year. Risk Calculation Result Market 99% one-day VaR = 2.326 × 1.2% × $50m $1.40 million Credit Expected loss = PD × LGD × EAD = 2% × 45% × $20m $180,000 Liquidity Coverage = $12bn ÷ $10bn 120%, above the 100% minimum Operational 25 events × $40,000 average loss $1,000,000 a year Result: four different units, so the risks cannot simply be added; each needs its own limit, its own owner and its own early-warning trigger.
Recap
Risk teams work with four types: market, credit, liquidity and operational risk, each with its own tools (VaR and stress tests, collateral and limits, LCR and funding lines, controls and reconciliation). Systemic crises, 2008 above all, are several types failing at once.
What the full article covers
In the full article I take you through these sections:
■8.4 Mortgage Lending — How a House Purchase Connects to the Whole System
■8.5 Risk Management and Compliance in Practice
■8.6 The Four Types of Financial Risk
It includes worked examples, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume I: Global Economy
Read the full article on FinoLib
The complete article, Types of Financial Risk: Four Kinds and How Mortgage Lending Works, with every worked example, diagram, quiz and source, is free to read in Volume I, Global Economy on finolib.com.
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