Mortgage Subprime Mortgage Crisis — Questions and Answers

Question 1: Which government-sponsored enterprises (GSEs) were placed into federal conservatorship in September 2008 due to their exposure to subprime mortgages?

Fannie Mae and Freddie Mac (Correct answer)
Ginnie Mae and Sallie Mae
FHA and VA
FDIC and OCC

Correct answer: Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac were taken into federal conservatorship by the FHFA in September 2008 after suffering massive losses from mortgage-backed securities.

Question 2: What is a 'liar loan' in the context of the subprime mortgage crisis?

A mortgage where borrowers self-certify income without documentation verification (Correct answer)
A loan with a deliberately misleading interest rate disclosure
A mortgage that resets to a higher rate without notice
A loan originated by unlicensed brokers

Correct answer: A mortgage where borrowers self-certify income without documentation verification

Liar loans, also called stated-income loans, allowed borrowers to self-report income without lenders verifying the information, leading to widespread fraud.

Question 3: What role did credit default swaps (CDS) play in amplifying the subprime mortgage crisis?

They allowed investors to bet on or hedge against mortgage defaults, spreading risk widely (Correct answer)
They guaranteed principal repayment on all mortgage-backed securities
They set maximum interest rates on subprime loans
They required lenders to hold minimum capital reserves

Correct answer: They allowed investors to bet on or hedge against mortgage defaults, spreading risk widely

Credit default swaps let institutions like AIG insure mortgage bonds without holding adequate capital reserves, creating massive interconnected exposure when defaults surged.

Question 4: What was the 'originate-to-distribute' model that contributed to the subprime crisis?

Lenders originate loans intending to sell them, removing incentive to ensure loan quality (Correct answer)
Banks distribute mortgage applications among multiple underwriters for risk spreading
A federal program to originate loans and distribute them to low-income borrowers
A system where loan officers distribute leads to competing mortgage brokers

Correct answer: Lenders originate loans intending to sell them, removing incentive to ensure loan quality

The originate-to-distribute model meant lenders earned fees at closing and immediately sold loans, eliminating any long-term stake in whether borrowers could repay.

Question 5: Which 2010 legislation created the Consumer Financial Protection Bureau (CFPB) largely in response to the subprime mortgage crisis?

Dodd-Frank Wall Street Reform and Consumer Protection Act (Correct answer)
Sarbanes-Oxley Act
Glass-Steagall Restoration Act
Community Reinvestment Act Amendment

Correct answer: Dodd-Frank Wall Street Reform and Consumer Protection Act

The Dodd-Frank Act of 2010 established the CFPB to oversee consumer financial products and protect borrowers from predatory lending practices exposed during the crisis.

Question 6: What was a 'silent second' mortgage in the context of predatory subprime lending?

An undisclosed second lien used to cover a down payment, hidden from the primary lender (Correct answer)
A second mortgage that had no interest for the first five years
A government-backed subordinate loan for first-time homebuyers
A reverse mortgage taken out without the knowledge of heirs

Correct answer: An undisclosed second lien used to cover a down payment, hidden from the primary lender

Silent seconds were hidden second mortgages that funded down payments without the first lender's knowledge, creating undisclosed debt and misrepresenting borrower equity.

Question 7: What happened to U.S. home prices between the peak in 2006 and the trough around 2012?

They fell approximately 30% nationally, with some markets declining over 50% (Correct answer)
They fell approximately 10% nationally before recovering
They remained flat nationally but declined in sunbelt states only
They fell approximately 60% nationally across all markets

Correct answer: They fell approximately 30% nationally, with some markets declining over 50%

The S&P/Case-Shiller national home price index fell roughly 27–30% from peak to trough, with hard-hit markets like Las Vegas and Phoenix losing over 50% of their value.

Question 8: 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 9: 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 10: 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 11: 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 12: 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 13: 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 14: 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.

Question 15: What was the 'teaser rate' strategy used in many subprime adjustable-rate mortgages?

An artificially low initial interest rate that reset sharply higher after one to three years (Correct answer)
A discount offered to borrowers who paid two points upfront at closing
A guaranteed rate cap that prevented interest from exceeding a set ceiling
A promotional rate available only to borrowers with 20% down payments

Correct answer: An artificially low initial interest rate that reset sharply higher after one to three years

Teaser rates made loans appear affordable at origination but reset to much higher rates after an introductory period, causing payment shock and mass defaults when home values fell.

Question 16: What was the primary reason mortgage servicers often preferred foreclosure over loan modifications during the crisis?

Servicer fee structures and contractual obligations to MBS investors made modifications financially unattractive (Correct answer)
Federal law prohibited servicers from modifying loan terms without court approval
Foreclosure was cheaper to execute than modifying a loan in all circumstances
Servicers lacked the legal authority to contact delinquent borrowers

Correct answer: Servicer fee structures and contractual obligations to MBS investors made modifications financially unattractive

Servicer compensation was tied to collecting payments and foreclosure fees, while pooling and servicing agreements often restricted modifications, creating perverse incentives against helping borrowers.

Question 17: What is 'robo-signing' as it came to light after the subprime crisis?

Bank employees signing foreclosure documents en masse without reviewing them, often fraudulently (Correct answer)
An automated system that approved mortgage applications without human review
Software that electronically signed closing documents on behalf of absent borrowers
A program that automatically generated credit scores without human oversight

Correct answer: Bank employees signing foreclosure documents en masse without reviewing them, often fraudulently

Robo-signing involved bank employees or contractors signing thousands of foreclosure affidavits per day without reading them, leading to a national foreclosure freeze and major bank settlements.

Question 18: What was the Community Reinvestment Act (CRA), and how was it incorrectly blamed for the subprime crisis?

A 1977 law encouraging lending to low-income areas that critics blamed but studies found accounted for a small fraction of subprime loans (Correct answer)
A law that mandated 20% of all bank loans be made to subprime borrowers
A federal program that guaranteed repayment of all loans made in underserved communities
A rule requiring banks to lower credit standards for all applicants equally

Correct answer: A 1977 law encouraging lending to low-income areas that critics blamed but studies found accounted for a small fraction of subprime loans

The CRA encouraged banks to lend in all communities they served, but studies found CRA-covered lenders made a small proportion of subprime loans and had lower default rates than non-CRA lenders.

Question 19: What was the HARP (Home Affordable Refinance Program) created to address?

Helping underwater homeowners with Fannie/Freddie-backed loans refinance at lower rates (Correct answer)
Providing cash grants to first-time homebuyers in foreclosure-heavy neighborhoods
Allowing banks to write off bad mortgage debt on their balance sheets tax-free
Creating a federal fund to purchase and demolish vacant foreclosed homes

Correct answer: Helping underwater homeowners with Fannie/Freddie-backed loans refinance at lower rates

HARP, launched in 2009, allowed homeowners with little or no equity in Fannie Mae or Freddie Mac loans to refinance at lower interest rates, reducing monthly payments and default risk.

Question 20: Which investment bank's collapse in March 2008 is often cited as an early warning signal of the subprime crisis's severity?

Bear Stearns (Correct answer)
Goldman Sachs
Morgan Stanley
Merrill Lynch

Correct answer: Bear Stearns

Bear Stearns collapsed in March 2008 and was acquired by JPMorgan Chase with Fed assistance, signaling how deeply subprime losses had penetrated major financial institutions.

Question 21: What is a 'jumbo' mortgage, and how did jumbo loans behave differently in the subprime crisis?

Loans exceeding conforming loan limits that couldn't be sold to GSEs and faced tighter credit markets (Correct answer)
Mortgages with unusually large monthly payments regardless of loan size
Government-backed loans for multifamily properties with more than four units
Loans made to borrowers with credit scores above 800 at preferential rates

Correct answer: Loans exceeding conforming loan limits that couldn't be sold to GSEs and faced tighter credit markets

Jumbo loans exceeded GSE conforming limits and relied on private securitization markets, which froze during the crisis, making jumbo financing scarce and expensive even for creditworthy borrowers.

Mortgage Subprime Mortgage Crisis

Which government-sponsored enterprises (GSEs) were placed into federal conservatorship in September 2008 due to their exposure to subprime mortgages?

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