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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

A bank securitizes mortgage loans and sells the resulting securities, but also sponsors an off-balance-sheet conduit that holds long-term asset-backed securities funded by short-term asset-backed commercial paper. The bank provides a liquidity backstop to the conduit. In the 2007 market turmoil, which risk most directly caused the bank's losses to return to its balance sheet?

The conduit relied on short-term commercial paper to fund long-term securities. When investors refused to roll the paper over in 2007, the sponsoring bank had to honor its liquidity commitments, bringing the assets and their losses back onto its own balance sheet.

  1. AThe conduit's commercial paper could not be rolled over, so the bank had to honor its liquidity supportCorrect
  2. BThe mortgages had fixed rather than floating rates, so the conduit had prepayment protection
  3. CThe rating agencies upgraded the senior tranches, forcing the conduit to sell them
  4. DThe conduit's assets were marked to model, which reduced the bank's regulatory capital requirement

Explanation

Conduits financed long-term assets with short-term paper, creating maturity mismatch. When investors stopped buying commercial paper in 2007, sponsors had to draw on liquidity lines or take assets back on balance sheet. The other options do not describe the mechanism, and upgrades did not occur.

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