Financial Risk Manager Part 1
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A novice risk analyst is tasked with summarizing the key events that precipitated the financial crisis of 2007 – 2009. As part of their task, they delve into the role of subprime mortgages as a factor influencing the crisis. Which of the following statements correctly characterizes the impact or role of these mortgages in the period leading up to the financial crisis?
Other
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TTanishq
A
Rigid documentation requirements for prospective borrowers led to a liquidity crisis in real estate due to a shortage of eligible borrowers.
B
The loan-to-value ratios for new subprime borrowers consistently declined in the years prior to the crisis.
C
The majority of mortgage brokers received their compensation based on the performance of the subprime mortgages they originated, and had to refund large commissions as these loans started to default.
D
Many subprime mortgages experienced a sharp increase in interest rates after an initial period of low rates, causing some borrowers to fall into default.
Explanation:
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.
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