Question

In: Economics

Describe one concrete example of how financial institutions took enormous risks using MBSs, CDOs, or CDSs


Describe one concrete example of how financial institutions took enormous risks using MBSs, CDOs, or CDSs . Explain how these risks contributed to what the author calls "the fragile house of cards upon which the American financial system what built."

Describe how compensation systems encouraged risk. Be specific. Briefly explain how these compensations systems contributed to what the author calls "the fragile house of cards upon which the American financial system was built."

Briefly describe what a rating agency is and give an example. Then, describe one of the reasons, given in the text, that explains why rating agencies failed to accurately rate mortgage-related securities in the years leading up to the financial crisis. (Consult pp. 79-81 in the text.).

Solutions

Expert Solution

One incidence when the financial institutions took an enormous risk using the mortgage-backed security is the subprime crisis of 2008. In this incident, a huge amount of loans were given to the general public without properly evaluating the loan takers ability to pay them back. All these loans were backed by an asset.

  • First, a huge amount of loans were dispersed to the general people. Without checking their ability to pay those backs.
  • These loans were backed by the assets these people mortgaged, which would be sold and the amount will be recovered if the individual is not able to pay the loan back.

This is considered as a house of cards because the whole system is not stable. When the crisis hit, people were not able to pay their loans back. So, the banks started to auction their mortgaged property but those loans were distributed so recklessly that the number of people who were not able to service their loan increases exponentially bringing the huge amount of assets in the market and crashing its price. When the price of the property was reduced people who were servicing their loan found it much more beneficial to default on their payment which was more than the mortgaged property further making the situation even worse. More and more people defaulted and banks went insolvent.

Just like the house of cards, when the crisis triggered there was no stopping and the whole system i.e. the bubble collapsed.   


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