Credit Risk Management Practice Exam

What is a primary consequence of lax lending standards in subprime mortgage lending?

1. Increased transparency for investors

2. A surge in home ownership rates

3. Higher default rates among borrowers

4. Lower interest rates across the market

The correct answer is: Higher default rates among borrowers

The primary consequence of lax lending standards in subprime mortgage lending is the higher default rates among borrowers. When lenders relax their requirements for approving loans, they often extend credit to individuals who may not have the financial capability or creditworthiness to manage the debt responsibly. This includes offering loans to borrowers with poor credit histories, low income, or insufficient documentation of their ability to repay. As these borrowers take on mortgages they can't afford, the likelihood of missed payments or default rises significantly. Such circumstances lead to higher default rates, which not only affect individual borrowers but can also have broader implications for the financial system, including increased losses for lenders, potential downturns in housing markets, and ripple effects throughout the economy. In contrast, options suggesting increased transparency for investors, a surge in home ownership rates, or lower interest rates do not accurately reflect the consequences of lax lending standards. In fact, while lax standards may temporarily boost home ownership rates, the long-term effects typically include instability and higher default rates, indicating a troubling cycle that can undermine both the housing market and the financial institutions involved.