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IAI Actuarial Core Principles · Business Economics · Recent macroeconomic history

Which feature of the US housing market before 2007 most directly allowed weak lending standards to spread risk across the global financial system?

Securitisation, in which mortgages were pooled and sold to investors, weakened lenders' incentive to screen borrowers because default risk was passed on. Poor-quality loans were then spread through the global financial system, which helps explain how a US housing problem became a worldwide crisis.

  1. ABanks kept all mortgages on their own balance sheets until maturity
  2. BMortgages were pooled into securities and sold to investors, reducing the originator's incentive to screen borrowersCorrect
  3. CCentral banks fixed mortgage rates at a constant level
  4. DGovernments guaranteed all household deposits at zero cost
  5. Mortgage lending was restricted to borrowers with large deposits

Explanation

Under the originate-and-distribute model, lenders sold loans into securitisations and so bore little of the default risk. This weakened screening incentives and spread poor-quality assets worldwide. Holding loans to maturity would have kept incentives aligned, so that option is wrong.

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