Chapter 10 - Anatomy Of The Great Financial Crisis of 2007-2009
Chapter 10 - Anatomy Of The Great Financial Crisis of 2007-2009
Chapter 10 - Anatomy Of The Great Financial Crisis of 2007-2009
1. Which of the following was a key factor in the build-up to the 2007-2009 financial crisis?
A. High interest rates that made borrowing more expensive
B. A reduction in the number of subprime mortgages
C. Historically low interest rates that encouraged borrowing and inflated house prices
D. A government crackdown on mortgage lenders
Low interest rates made borrowing cheaper, which encouraged people to take on mortgages, driving up house prices and contributing to an unsustainable housing market.
2. What role did securitization play in the build-up to the 2007-2009 financial crisis?
A. It increased the credit risk borne by lenders
B. It allowed mortgages to be easily repackaged and sold to investors, reducing credit risk for originators
C. It made it harder for investors to access mortgage-backed securities
D. It led to stricter lending standards
Securitization allowed banks to offload the credit risk of mortgages to other investors, making them less concerned with the credit quality of borrowers.
3. What caused the liquidity issues for banks during the financial crisis?
A. Banks held large amounts of cash reserves without risk
B. Banks over-invested in long-term government bonds
C. Banks financed long-term assets through short-term liabilities, creating a maturity mismatch
D. Banks were unable to borrow from central banks
Banks relied on short-term liabilities to finance long-term assets, leading to liquidity risk when short-term funding sources became unavailable during the crisis.
4. What was one of the major consequences of Lehman Brothers' bankruptcy in 2008?
A. A significant rise in housing prices
B. The immediate resolution of the subprime mortgage crisis
C. The stabilization of global financial markets
D. A massive loss of confidence and a freeze in the interbank lending market
Lehman Brothers' bankruptcy triggered a loss of confidence in the financial system, freezing the interbank lending market and escalating the financial crisis.
5. Which institution was bailed out during the 2007-2009 financial crisis to prevent further systemic issues?
A. The Federal Reserve
B. American International Group (AIG)
C. General Motors
D. Bank of America
AIG was bailed out by the U.S. government to prevent further systemic issues, as its collapse would have caused widespread financial instability.
6. Which of the following best describes a subprime mortgage?
A. A loan made to a borrower with excellent credit and low loan-to-value ratio.
B. A loan made to a borrower with poor credit and a high loan-to-value ratio.
C. A loan made to a borrower with poor credit and typically a high loan-to-value ratio or low equity.
D. A loan made to a borrower with no credit history but strong employment.
Subprime mortgages are typically made to borrowers with poor credit histories and high loan-to-value ratios, posing higher risks for lenders.
7. What is a characteristic feature of a 2-28 adjustable-rate mortgage (ARM)?
A. The interest rate remains fixed for the entire term of the loan.
B. The interest rate is low for the first 2 years and then increases significantly for the next 28 years.
C. The mortgage is interest-only for the first 2 years, after which it becomes fixed-rate.
D. The mortgage is fixed-rate for the first 28 years and adjustable thereafter.
A 2-28 ARM has a low fixed rate for the first 2 years, after which the rate adjusts to a higher variable rate for the remaining 28 years.
8. Which of the following was a consequence of 100% loan-to-value subprime mortgages?
A. No equity cushion for the lender in case of default, increasing the risk of loss.
B. The borrower had to provide a large upfront payment, reducing the loan amount.
C. The borrower received a fixed interest rate throughout the mortgage term.
D. The loan was based on the borrower’s assets and income verification.
A 100% loan-to-value mortgage has no upfront payment, meaning the lender has no equity cushion in case the borrower defaults.
9. What is a characteristic of NINJA loans?
A. The loan is only available to high-income earners with significant assets.
B. The loan requires collateral in the form of property or assets.
C. The borrower has no income, no job, and no assets, making the loan extremely risky.
D. The loan is structured as an adjustable-rate mortgage with a low teaser rate.
NINJA loans were extended to borrowers with no income, no job, and no assets, making them highly speculative and risky.
10. What is the main problem associated with liar loans?
A. The borrower is required to provide extensive documentation about their income and assets.
B. Little or no evidence is collected to verify the borrower’s employment and income claims.
C. The loan is secured by a low-interest mortgage and is less risky for lenders.
D. The borrower is expected to provide a large down payment to reduce lender risk.
Liar loans were problematic because there was little verification of the borrower’s claims regarding income and employment, leading to higher default risks.
11. What was one of the primary hopes of subprime borrowers who were property speculators during the housing boom?
A. They hoped to refinance at lower interest rates after their teaser period.
B. They hoped to refinance to a similar or better product or sell the house for a profit.
C. They hoped to reduce the loan amount by paying off the principal early.
D. They hoped to extend their mortgage period without penalty.
Subprime borrowers hoped to either refinance to a better mortgage or sell their property at a profit as house prices continued to increase.
12. What happened when house prices declined, according to the subprime borrowers' situation?
A. Borrowers were able to refinance their loans at even better terms.
B. Borrowers continued to make their mortgage payments despite negative equity.
C. Many borrowers found themselves in negative equity and defaulted on their loans.
D. House prices remained stable despite the economic downturn.
As house prices declined, many subprime borrowers were in negative equity and chose to default on their loans, leading to foreclosures.
13. What is the "originate-to-distribute" (OTD) model in mortgage lending?
A. Lenders hold mortgages on their balance sheet.
B. Lenders sell the mortgages and transfer the risks to third-party investors through securitization.
C. Lenders provide mortgages only to prime borrowers.
D. Lenders issue mortgages to borrowers without the need for any credit checks.
Under the OTD model, lenders sell mortgages through securitization, moving the loans off their balance sheets and transferring risk to other investors.
14. What is a collateralized debt obligation (CDO)?
A. A type of bond backed by a single mortgage loan.
B. A type of stock issued by mortgage lenders.
C. A mortgage-backed security offering fixed interest payments.
D. A structured financial product that pools various assets, including mortgages, and slices them into different tranches.
A CDO pools various financial assets, such as mortgages, and slices them into tranches, each with different levels of risk and return.
15. What was the consequence of the overly complex and opaque structures like CDOs in the financial market?
A. Investors were able to easily understand the risks and make informed decisions.
B. Investors found it difficult to value and understand what they were buying, even during normal times.
C. The complexity resulted in a highly profitable market for investors who understood the structures.
D. The structures were only opaque to novice investors and not to sophisticated ones.
CDO structures were complex and opaque, making it hard for even experienced investors to understand their true value and risks.
16. What was the primary motivation behind banks using short-term wholesale funding methods like asset-backed commercial paper (ABCP) and repurchase agreements (repos)?
A. To ensure long-term funding stability
B. To reduce funding costs
C. To reduce the amount of collateral needed
D. To increase profitability through higher interest rates
Banks used short-term funding methods like ABCP and repos to reduce funding costs, but this led to an asset-liability maturity mismatch.
17. What is a characteristic of asset-backed commercial paper (ABCP)?
A. It is short-term financing backed by collateral, such as mortgages or credit card loans.
B. It is a form of long-term debt issued by financial institutions.
C. It is unsecured and does not require collateral.
D. It is only used for government bonds.
ABCP is a form of short-term financing that is backed by collateral such as credit card loans or mortgages.
18. What is a significant risk associated with using short-term liabilities like ABCP and repos to finance long-term assets?
A. The risk of default on long-term assets
B. The risk of short-term liabilities being rolled over at higher interest rates
C. The risk of excessive short-term liquidity
D. The risk of an asset-liability maturity mismatch
Using short-term liabilities like ABCP and repos to finance long-term assets creates an asset-liability maturity mismatch, which can lead to liquidity issues.
19. Which of the following describes the purpose of a haircut in the context of repurchase agreements (repos)?
A. To reduce the credit risk by ensuring the lender is over-collateralized
B. To increase the interest rate on the repurchase agreement
C. To increase the loan amount for the borrower
D. To secure the lender from asset depreciation
A haircut reduces credit risk by ensuring the lender receives collateral worth more than the loan value, compensating for any potential depreciation.
20. In the context of repurchase agreements (repos), what is the collateral typically used to secure the short-term borrowing?
A. Only real estate assets
B. Commercial paper
C. Government bonds or high-quality corporate bonds
D. Mortgages
In repos, collateral typically includes government bonds or high-quality corporate bonds to secure the short-term borrowing.
21. What was a significant risk faced by SIVs during the 2007 financial crisis?
A. Market liquidity risk due to volatile house prices
B. Funding liquidity risk due to reliance on short-term funding sources
C. Operational risk due to asset mismanagement
D. Interest rate risk caused by long-term borrowing
SIVs were heavily reliant on short-term funding through ABCP and repos, which exposed them to significant funding liquidity risk when these markets dried up during the crisis.
22. What was the primary cause of the ABCP and repo market shutdown in 2007?
A. Declining asset prices and loss of confidence in the quality of assets
B. Interest rate hikes by central banks worldwide
C. Overregulation of the short-term funding market
D. Increase in the supply of collateralized debt obligations (CDOs)
As house and mortgage-backed security prices declined, lenders became hesitant to extend further loans, leading to a freeze in the ABCP and repo markets.
23. How did the liquidity crisis in 2007 affect hedge funds?
A. Hedge funds started buying distressed assets to capitalize on market recovery
B. Hedge funds increased their leverage to take advantage of low asset prices
C. Hedge funds were forced to sell higher-quality assets to meet margin calls
D. Hedge funds increased their investments in real estate to diversify
Hedge funds faced margin calls and had to sell higher-quality assets to meet these calls, further exacerbating the crisis.
24. What does an increase in the LIBOR-OIS spread indicate during a financial crisis?
A. Decrease in market volatility
B. Higher confidence in the interbank lending market
C. Increased availability of short-term funding
D. Increased credit risk and reluctance to lend in the interbank market
A rise in the LIBOR-OIS spread signifies higher perceived credit risk, indicating reluctance to lend in the interbank market.
25. What is a key lesson learned from the 2007 financial crisis regarding short-term funding sources?
A. Overreliance on long-term funding sources is risky
B. Overreliance on short-term funding sources is dangerous during times of crisis
C. Short-term funding is always sufficient for financial institutions
D. Short-term funding sources are not relevant during a crisis
The crisis highlighted the dangers of overrelying on short-term funding, which can evaporate quickly during a financial crisis.
26. What was one of the key actions taken by the Federal Reserve during the financial crisis of 2007-2008?
A. Increasing interest rates to control inflation
B. Selling off toxic assets to the private sector
C. Providing long-term loans secured by high-quality collateral
D. Restricting the money supply to reduce credit risk
The Federal Reserve provided long-term loans secured by high-quality collateral as a response to the financial crisis to maintain liquidity and stabilize markets.
27. What did the Federal Reserve allow investment banks to do during the crisis that was not available to them previously?
A. Borrow from private commercial banks at lower interest rates
B. Borrow directly from the Fed via the discount window
C. Purchase toxic assets from financial institutions
D. Receive government bailouts to restructure their operations
Investment banks were allowed to borrow directly from the Federal Reserve via the discount window, which was previously unavailable to them before the crisis.
28. Which of the following was NOT part of the actions taken by the Federal Reserve during the financial crisis?
A. Providing liquidity against high-quality illiquid assets
B. Providing funding to purchase asset-backed commercial paper
C. Acquiring assets issued by Fannie Mae and Freddie Mac
D. Restricting loans to commercial banks to reduce inflation
The Federal Reserve did not restrict loans to commercial banks; rather, it provided liquidity support through various channels, including purchasing asset-backed commercial paper.
29. What is the Term Auction Facility (TAF) implemented by the Federal Reserve during the crisis?
A. A mechanism to buy government bonds from financial institutions
B. A program for emergency lending to foreign banks
C. A facility that provided funds to depository institutions through auctions
D. A policy to restrict short-term borrowing by financial institutions
The Term Auction Facility (TAF) was established to provide funds to depository institutions, offering an alternative to the traditional discount window borrowing process.
30. Which of the following programs was a government bailout of Fannie Mae and Freddie Mac in 2008?
A. Troubled Asset Relief Program (TARP)
B. Primary Dealer Credit Facility (PDCF)
C. Term Auction Facility (TAF)
D. The Emergency Economic Stabilization Act (EESA)
The government bailout of Fannie Mae and Freddie Mac in 2008 was part of the Troubled Asset Relief Program (TARP), which aimed to stabilize the housing market and financial institutions.
31. What was one of the primary factors that fueled the rapid increase in house prices leading up to the financial crisis of 2007–2009?
A. High inflation rates across the economy
B. Low interest rates and easy access to credit
C. Tight monetary policy and reduced liquidity
D. High government intervention in the housing market
In the run-up to the crisis, low interest rates and easy access to credit fueled a rapid increase in house prices.
32. Which of the following factors contributed to the financial crisis of 2007–2009?
A. Increased government regulation of financial markets
B. A shift from the originate-to-hold to the originate-to-distribute model
C. Relaxation of lending standards and growth of subprime lending
D. Tightening of liquidity risk management by banks
The shift to the originate-to-distribute model and relaxed lending standards contributed to the growth of subprime lending, fueling the crisis.
33. What are subprime mortgages?
A. Mortgages offered to borrowers with a perfect credit history
B. Mortgages with low interest rates but long repayment periods
C. Residential loans offered to high-risk borrowers
D. Mortgages provided by government agencies to low-income individuals
Subprime mortgages are residential loans given to high-risk borrowers with poor credit histories.
34. What role did rating agencies play in the financial crisis of 2007–2009?
A. They provided accurate and conservative ratings for all financial products
B. They gave unrealistically high ratings to senior tranches of CDOs backed by subprime mortgages
C. They failed to rate any mortgage-backed securities during the crisis
D. They focused only on government bonds, avoiding CDOs entirely
Rating agencies contributed to the crisis by providing unrealistically high ratings, especially to senior tranches of CDOs backed by risky subprime mortgages.
35. How did banks increase their exposure to liquidity risk prior to the financial crisis of 2007–2009?
A. By funding long-term assets using long-term debt
B. By holding large reserves of liquid capital
C. By funding long-term assets through short-term sources like asset-backed commercial paper and repos
D. By reducing the number of short-term loans they issued
Banks increased their exposure to liquidity risk by funding long-term assets using short-term funding sources such as asset-backed commercial paper and repos.
36. What was the role of central banks in preventing further systemic risks during the financial crisis of 2007–2009?
A. They restricted liquidity to prevent market overheating
B. They lowered interest rates and provided liquidity support to prevent systemic collapse
C. They increased government spending to stimulate economic growth
D. They imposed capital controls to prevent currency depreciation
Central banks lowered interest rates and provided liquidity support to prevent further systemic risks during the financial crisis.
37. What was the effect of the Lehman Brothers default on the financial system during the 2007–2009 crisis?
A. It had little effect on the global financial system
B. It caused a loss of confidence in the financial system, leading to banks refusing to lend to each other
C. It led to an immediate recovery in the housing market
D. It had a positive impact by stabilizing the financial markets
The Lehman Brothers default caused a loss of confidence, leading to a refusal of banks to lend to each other and triggering widespread financial instability.
38. Which of the following was a key element of the "originate-to-distribute" model that contributed to the financial crisis?
A. Banks retained the loans they originated on their balance sheets
B. Banks provided long-term loans to borrowers with low credit risk
C. Banks originated loans and sold them to other institutions, often with inadequate oversight
D. Banks held most of the loans they originated until maturity
The "originate-to-distribute" model involved banks originating loans and then selling them to other institutions, which reduced the incentive to assess the quality of the loans.
39. What was the main reason for banks' increased reliance on short-term funding prior to the financial crisis of 2007–2009?
A. Long-term funding sources became too expensive for banks
B. Short-term funding was more easily accessible and cheaper
C. Banks had sufficient long-term capital to cover all of their assets
D. Banks were required by regulators to use more short-term funding
Banks relied on short-term funding because it was more easily accessible and cheaper than long-term sources, increasing their exposure to liquidity risks.
40. What was the role of central banks in providing liquidity support during the financial crisis?
A. Central banks restricted liquidity to control inflation
B. Central banks provided liquidity support by lowering interest rates and offering emergency loans
C. Central banks focused on raising interest rates to curb financial instability
D. Central banks reduced the amount of money in circulation to strengthen the economy
To prevent a complete collapse, central banks provided liquidity support by lowering interest rates and offering emergency loans to struggling financial institutions.
41. Which of the following programs was implemented by the U.S. government to purchase toxic assets from financial institutions during the financial crisis?
A. Federal Reserve Asset Recovery Program
B. Troubled Asset Relief Program (TARP)
C. Emergency Economic Stabilization Program
D. Homeowners Assistance Program
The Troubled Asset Relief Program (TARP) was implemented to purchase toxic assets from financial institutions, stabilizing the financial system during the crisis.
42. How did central banks' balance sheets change as a result of their interventions during the financial crisis of 2007–2009?
A. Their balance sheets remained stable with no significant change
B. Their balance sheets expanded significantly due to liquidity support and asset purchases
C. Their balance sheets contracted as a result of financial austerity measures
D. Their balance sheets shrank due to the sale of toxic assets
Central banks' balance sheets expanded significantly due to liquidity support and asset purchases to stabilize the financial system.
43. Under the "originate-to-distribute" model, how did the transfer of credit risk to investors affect lenders' behavior?
A. Lenders increased their regulatory capital and tightened lending criteria
B. Lenders reduced the amount of mortgages sold to special investment vehicles (SIVs)
C. Lenders needed to hold less regulatory capital and relaxed their lending criteria
D. Lenders became more cautious and reduced the issuance of collateralized debt obligations (CDOs)
Under the "originate-to-distribute" model, lenders sold mortgages to special investment vehicles (SIVs), transferring credit risk to other investors. This allowed lenders to hold less regulatory capital and relax lending criteria.
44. Why did rating agencies provide unrealistically high assessments of collateralized debt obligations (CDOs) during the financial crisis?
A. Rating agencies had no involvement in assessing the risk of CDOs
B. The conflict of interest between rating agencies and issuers of CDOs led to unrealistically high ratings
C. Rating agencies were overly conservative in their assessment of the senior tranches of CDOs
D. Rating agencies relied on inaccurate models to assess the risk of CDOs
Rating agencies provided high ratings due to a conflict of interest with issuers of CDOs, which resulted in unrealistic assessments of risk, particularly for senior tranches of CDOs.
45. How did banks' use of short-term funding sources, such as asset-backed commercial paper (ABCP) and repos, expose them to liquidity risk during the financial crisis?
A. Banks were less vulnerable to liquidity risk because these funding sources were guaranteed
B. Banks were exposed to liquidity risk because short-term lenders refused to roll over loans during the crisis
C. Short-term funding sources became more expensive during the crisis, reducing liquidity risk
D. Short-term funding sources became easier to obtain during the crisis, reducing liquidity risk
Banks relied on short-term funding sources like ABCP and repos, which exposed them to liquidity risk when lenders refused to roll over loans during the financial crisis.
46. During the peak of the financial crisis, the discount window was made available to which group of financial institutions?
A. Only commercial banks that met reserve requirements
B. Only investment banks that held government bonds
C. Only central banks and international financial institutions
D. Both commercial banks and investment banks
At the peak of the crisis, the discount window, which was historically available only to commercial banks, was also made available to investment banks to provide liquidity support.
