Credit Risk Management Practice Exam

What is a key flaw in the securitization of subprime mortgages prior to the 2007 financial crisis?

1. Investment firms retained all default risks

2. Lending standards were overly stringent

3. Securitized products had a high level of transparency

4. Members of the securitization supply chain were incentivized to sell loans without retaining default risk

The correct answer is: Members of the securitization supply chain were incentivized to sell loans without retaining default risk

The improper incentives within the securitization supply chain played a significant role in the buildup to the 2007 financial crisis. Specifically, members of the securitization process, such as mortgage brokers, lenders, and investment banks, were often not held accountable for the default risk of the loans they originated. Their primary focus was to originate as many loans as possible to sell them off to investors, thereby removing themselves from the risk associated with those loans. This misalignment of incentives led to a lax approach to underwriting and a disregard for proper credit assessment, as the originating entities did not face consequences for the loans' performance once they were sold. Moreover, the lack of retention of default risk by the originators resulted in a proliferation of subprime mortgages, which were often granted to borrowers with poor credit histories, no documentation, or inadequate income verification. As the value of these securities was based on the expectation that housing prices would continue to rise, this ultimately created a dangerous bubble that burst when the housing market began to decline, leading to widespread defaults and the collapse of financial institutions. The other options reflect inaccuracies about the landscape of subprime mortgage securitization at the time. For example, investment firms did not retain all default risks; rather, they actively