Mortgage Subprime Mortgage Crisis 5 — Questions and Answers
Question 1: What was the global spread of the subprime mortgage crisis primarily caused by?
- International banks had purchased U.S. mortgage-backed securities, spreading losses worldwide (Correct answer)
- Subprime mortgage practices were replicated in every developed country simultaneously
- The U.S. Federal Reserve raised interest rates globally to address inflation
- Foreign governments had directly guaranteed U.S. subprime loans as collateral
Correct answer: International banks had purchased U.S. mortgage-backed securities, spreading losses worldwide
Banks in Europe, Asia, and elsewhere had bought U.S. MBS products, transmitting losses globally and turning a U.S. housing problem into the worst worldwide financial crisis since the Great Depression.
Question 2: What role did excessive leverage play in magnifying subprime crisis losses at major financial institutions?
- High debt-to-equity ratios meant small declines in asset values wiped out entire capital bases (Correct answer)
- Leverage allowed firms to buy more mortgages at below-market rates from distressed sellers
- Banks used leverage to hedge against falling home prices through short positions
- Leverage enabled institutions to hold more cash reserves in anticipation of losses
Correct answer: High debt-to-equity ratios meant small declines in asset values wiped out entire capital bases
Investment banks were leveraged 30-to-1 or more, meaning a 3% drop in asset values could eliminate all equity, triggering insolvency and panic selling that accelerated the crisis.
Question 3: What is 'mark-to-market' accounting, and why did it become controversial during the subprime crisis?
- Valuing assets at current market prices, which forced write-downs on illiquid MBS when markets froze (Correct answer)
- Pricing mortgages based on the original appraised value at loan origination
- A method of recording foreclosure losses only when properties are actually sold
- An accounting standard requiring banks to reserve 100% against all delinquent loans
Correct answer: Valuing assets at current market prices, which forced write-downs on illiquid MBS when markets froze
Mark-to-market required firms to value MBS at fire-sale prices in frozen markets, potentially exaggerating losses and triggering capital requirement violations, prompting debates about relaxing the rule.
Question 4: What does 'moral hazard' mean in the context of the subprime crisis bailouts?
- The risk that guaranteeing firms against losses encourages future reckless behavior (Correct answer)
- The ethical obligation of banks to disclose all mortgage risks to borrowers
- The legal principle holding executives personally liable for institutional fraud
- The requirement that bailout recipients donate profits to foreclosure relief funds
Correct answer: The risk that guaranteeing firms against losses encourages future reckless behavior
Critics argued that bailing out institutions like AIG and Citigroup rewarded risky behavior and sent the message that large banks would always be rescued, encouraging future excess.
Question 5: What was the 'National Mortgage Settlement' of 2012?
- A $25 billion agreement between 49 states and the five largest mortgage servicers over foreclosure abuses (Correct answer)
- A federal program that settled all outstanding subprime foreclosure cases through arbitration
- A Supreme Court ruling that voided all foreclosures conducted between 2007 and 2010
- A law requiring mortgage servicers to modify all delinquent loans to affordable terms
Correct answer: A $25 billion agreement between 49 states and the five largest mortgage servicers over foreclosure abuses
The 2012 National Mortgage Settlement required Bank of America, JPMorgan Chase, Wells Fargo, Citigroup, and Ally Financial to provide $25 billion in homeowner relief over robo-signing and foreclosure fraud.
Question 6: How did the Federal Reserve respond to the early stages of the financial crisis in 2007–2008?
- It cut the federal funds rate aggressively and created emergency lending facilities for financial institutions (Correct answer)
- It raised interest rates to combat the inflation caused by rising home prices
- It purchased all outstanding mortgage-backed securities directly from investors
- It imposed a temporary ban on short-selling of financial institution stocks
Correct answer: It cut the federal funds rate aggressively and created emergency lending facilities for financial institutions
The Fed slashed the federal funds rate from 5.25% to near zero and created facilities like the Term Auction Facility and Primary Dealer Credit Facility to inject liquidity into frozen credit markets.
Question 7: What is 'strategic default,' and why did it increase during the subprime crisis?
- Deliberately stopping mortgage payments on an underwater home even when able to pay, because it is financially rational (Correct answer)
- A lender strategy of selectively defaulting on securitization obligations to maximize recoveries
- A borrower tactic of paying only the minimum due each month to delay foreclosure indefinitely
- A bank practice of declaring technical default to accelerate loan repayment from creditworthy borrowers
Correct answer: Deliberately stopping mortgage payments on an underwater home even when able to pay, because it is financially rational
When homes lost 30–50% of their value, some financially capable homeowners chose strategic default because continuing to pay exceeded the economic benefit of owning an asset worth far less than the debt.
Mortgage Subprime Mortgage Crisis 5
What was the global spread of the subprime mortgage crisis primarily caused by?