Question

A mortgage company classifies its borrowers into three categories: Low Risk Medium Risk ind High Risk. from enerience ite ermonn. knows that: - 2% of low risk borrowers eventually default on their mortgages. - 10% of medium risk borrowers eventually default on their mortgages. - 13% of high risk borrowers eventually default on their mortgages. makes a profit on the portfolio?

Answer 1

The categorization of loan risk and borrower default relates to the banking practices that contributed to the 2008 recession,

involving aggressive lending, subprime and NINJA loans, and the securitization of mortgage loans, which led to widespread defaults and financial instability.

Step-by-step explanation:

The process by which banks classify loans into categories such as Low Risk, Medium Risk, and High Risk, and the risk associated with borrower default, is a fundamental aspect of banking and finance.

This classification becomes increasingly relevant when understanding the events that lead to the 2008 recession, where aggressive lending and the issuance of subprime and NINJA loans played a significant role. Banks that intended to securitize and offload these loans had less incentive to ensure borrowers could repay,

which led to a huge increase in mortgage defaults when economic conditions worsened.

Securitization, although useful for diversifying risk and providing capital, can result in banks reducing the scrutiny they apply to loan applications, especially in an environment where they can sell these loans as mortgage-backed securities.

A critical lesson learned from that period was that when a large scale of unexpected loan defaults happen, as in a recession, even well-prepared banks can find their assets sharply devalued.

This can lead to banks having negative net worth, a dire situation that can trigger financial instability or bank failure.