Mortgage Subprime Mortgage Crisis 3 — Questions and Answers
Question 1: What is 'negative amortization' and how did it contribute to the subprime mortgage crisis?
- Loan balances grow when payments don't cover accruing interest, leaving borrowers deeper in debt (Correct answer)
- A penalty charged when borrowers pay off their mortgage early
- The process of reducing loan principal faster than scheduled
- Interest charged retroactively when a borrower misses a payment
Correct answer: Loan balances grow when payments don't cover accruing interest, leaving borrowers deeper in debt
Negative amortization loans allowed minimum payments below the interest due, causing loan balances to increase and borrowers to owe more than the home's value when prices dropped.
Question 2: What was the Emergency Economic Stabilization Act of 2008 primarily designed to do?
- Authorize the Treasury to purchase toxic mortgage assets through the TARP program (Correct answer)
- Provide direct cash payments to homeowners facing foreclosure
- Nationalize major U.S. banks affected by mortgage losses
- Suspend foreclosure proceedings for two years
Correct answer: Authorize the Treasury to purchase toxic mortgage assets through the TARP program
The Emergency Economic Stabilization Act created the $700 billion Troubled Asset Relief Program (TARP), giving the Treasury authority to buy distressed mortgage-backed securities.
Question 3: How did collateralized debt obligation (CDO) squared products increase systemic risk during the subprime crisis?
- They repackaged existing CDO tranches into new securities, obscuring underlying mortgage risk (Correct answer)
- They divided individual mortgages into smaller pieces sold to multiple investors
- They guaranteed CDO returns using Treasury bonds as collateral
- They allowed banks to issue mortgages directly to pension funds
Correct answer: They repackaged existing CDO tranches into new securities, obscuring underlying mortgage risk
CDO-squared products pooled lower-rated CDO tranches into new securities, creating extreme complexity that masked the true concentration of subprime mortgage exposure.
Question 4: What does the term 'underwater mortgage' mean, as commonly used during the subprime crisis?
- The outstanding loan balance exceeds the current market value of the home (Correct answer)
- A mortgage with a floating rate that has risen above the borrower's payment capacity
- A loan made on a property in a flood zone without required insurance
- A delinquent loan that has been transferred to a government agency
Correct answer: The outstanding loan balance exceeds the current market value of the home
An underwater (or 'upside-down') mortgage means the borrower owes more than the home is worth, eliminating equity and making refinancing or selling at a profit impossible.
Question 5: Which rating agency practice most directly contributed to inflated ratings on subprime mortgage-backed securities?
- The issuer-pays model, where securities issuers paid rating agencies for ratings (Correct answer)
- Government mandates requiring AAA ratings for all federally backed mortgages
- A shortage of qualified analysts leading to cursory reviews
- International accounting standards that overstated collateral values
Correct answer: The issuer-pays model, where securities issuers paid rating agencies for ratings
The issuer-pays model created conflicts of interest because Moody's, S&P, and Fitch competed for business from the very banks whose products they rated, incentivizing favorable ratings.
Question 6: What is 'predatory lending' in the mortgage context, as highlighted by the subprime crisis?
- Imposing unfair or abusive loan terms on borrowers, often targeting vulnerable populations (Correct answer)
- Offering below-market rates to attract borrowers away from competitors
- Charging the maximum legally allowed interest rate on all subprime loans
- Lending only to borrowers with pristine credit to minimize default risk
Correct answer: Imposing unfair or abusive loan terms on borrowers, often targeting vulnerable populations
Predatory lending involves deceptive or exploitative practices—such as excessive fees, loan flipping, and balloon payments—often targeting elderly, minority, or financially unsophisticated borrowers.
Question 7: What effect did the subprime mortgage crisis have on the broader U.S. economy, as classified by the NBER?
- It triggered the Great Recession, which officially lasted from December 2007 to June 2009 (Correct answer)
- It caused a mild slowdown that lasted only two quarters before recovery
- It led to a depression that lasted from 2007 to 2015
- It only affected the financial sector with no measurable GDP impact
Correct answer: It triggered the Great Recession, which officially lasted from December 2007 to June 2009
The National Bureau of Economic Research (NBER) dated the Great Recession from December 2007 to June 2009, making it the longest U.S. recession since World War II.
Mortgage Subprime Mortgage Crisis 3
What is 'negative amortization' and how did it contribute to the subprime mortgage crisis?