Credit Risk Management Practice Exam

Which issue is linked to moral hazard in the context of subprime mortgage securitization?

1. Excessive due diligence

2. Investor understanding of loan risks

3. Originators lacking incentives to ensure good loan quality

4. Strict enforcement of loan repayment

The correct answer is: Originators lacking incentives to ensure good loan quality

The issue linked to moral hazard in the context of subprime mortgage securitization is that originators lack incentives to ensure good loan quality. Moral hazard arises when one party in a transaction takes risks because they do not have to bear the consequences of those risks. In the case of subprime mortgage securitization, lenders (or originators) may approve loans without thoroughly evaluating the borrower's ability to repay, knowing that they can sell those loans to investors after securitization. When originators are compensated for volume rather than the quality of loans, there is a misalignment of incentives. They might focus on generating as many loans as possible to maximize their profits, disregarding the risk associated with lending to borrowers who are less likely to pay back their loans. This results in a lower overall quality of loans that are securitized, which can lead to higher default rates and significant losses for investors. In contrast, the other issues mentioned are not directly related to the aspect of moral hazard. Excessive due diligence would lead to better loan quality, investor understanding of loan risks pertains more to education and awareness, and strict enforcement of loan repayment focuses on borrower behavior rather than on the incentives of the loan originators. Thus, the most pertinent issue related to moral