Financial Risk Manager Part 1

In the years leading up to the financial crisis, subprime mortgages often utilized adjustable-rate mortgage (ARM) structures. These mortgages typically offered borrowers a low introductory interest rate for a limited period, known as the teaser rate. However, once this initial period ended, the interest rates on these mortgages would reset to significantly higher levels. As a result, many borrowers who initially qualified for the mortgage based on the lower teaser rate found themselves unable to afford the higher payments when the rates reset. This led to a rise in defaults among subprime borrowers, contributing to the overall crisis.

Why other options are incorrect:

• A: Strict documentation requirements were not a leading cause of the financial crisis. In fact, the opposite was true, as there were instances of lax documentation requirements that allowed unqualified borrowers to obtain subprime mortgages.
• B: In the years preceding the crisis, loan-to-value ratios for subprime borrowers actually tended to increase, meaning borrowers were taking on larger loans relative to the value of their homes. This increased their risk of default when home prices began to decline.
• C: Mortgage brokers typically received upfront commissions based on loan origination volume, not performance-based compensation tied to loan performance over time.