Question

James borrows $300,000 for a home from Bank A. Bank A resells the right to collect on that loan to Bank B. Bank B securitizes that loan with hundreds of others and sells the resulting security to a state pension plan, which at the same time purchases an insurance policy from a company called AIG that will pay off if James and the other people whose mortgages are in the security can’t pay off their mortgage loans. Suppose that James and all the other people can’t pay off their mortgages. Which financial entity is legally obligated to suffer the loss?

a. Bank A

b. Bank B

c. the state pension plan

d. AIG

Short answer

The correct answer is option d) AIG.

Step-by-step solution

Step 1. Explanation for the correct answer

The incidence of the loan finally comes on AIG. It is because, that the state pension security has purchased an insurance plan with AIG. So the responsibility of those loans is indirectly transferred to AIG, which will only suffer the loss.

Step 2. Explanation for incorrect options

Bank A doesn’t need to suffer the loss as they have already transferred the burden to Bank B by reselling the rights to collect a loan to bank B.

Bank B doesn’t have to suffer the loss as they have securitized the loan with 100 others and sold the resulting security to the state pension. So they have transferred the burden to the state pension security.

The state pension security has insured these mortgages by buying an insurance policy from AIG. So they are also free from the burden. The final burden falls on AIG.