Question

I need 7-8 sentences responding to each paragraph written by my peers. Please make sure each paragraph is error/grammar free. Please separate each paragraph written by number 1 and 2. Thanks, Chegg

1- The financial crisis in the United States in 2008-09 was caused by a lack of understanding of probability. Do you think this statement is correct? Why or why not? Please find evidence to support your argument.The statement is correct. Work in risk management has produced a large number of Nobel winners. Sometimes it feels when markets drop the chances of this happening was zero to begin with. No risk management model covers all conceivable possibilities. Social sciences are often based on probabilities.

Here is what happened in the crisis. The money to investors comes from homeowners and if people defaulted less money would flow to the banks and thus the investors. The investment banks put all of the mortgages into a box and called it collateralized debt obligations (CDO's). These packages were sold to others like hedge funds and banks. Some of the mortgages were not very risky but other were subprime. This is were the probability comes in.

The reality is that the banks underwrote very risky assets and insured them with credit default swaps. Underlying these are statistics and probability. The banks predicted that the mortgages, which had been split into solid, okay, and very risky divisions, would stay mostly intact and could gain a AAA credit rating. The small probability that some would go under was a bearable risk. These were going to be insured directly through banks. Otherwise the banks could be sold on the market for ever increasing house prices. The probability that default would happen was in fact much higher than thought. The expected negative return per default situation turned out to be very high. The probability is not constant, that is, it changes over time and is not homogeneous. As more people defaulted more houses went on the market. The more supply the less value to the house. The less market value the less willing people were to pay because they became underwater. This resulted in a reflexive feedback loop increasing the probability of default. In summary, a lack of understanding of probability caused the 2008-2009 financial crisis here in the United States.

2-I think it is correct. Since Fannie Mae and Freddie Mac of government-sponsored mortgages provide loans to borrowers with lower credit scores, the risk of default on such loans is high, so the possibility of these borrowers not repaying the loan is ignored. The root cause is the excessive expansion of housing loans and the lack of strict risk control; excessive innovation in financial products, a large number of structured products that are too complex, difficult to accurately estimate, and risk opaque; financial institutions have excessive leverage and defects in risk management models; financial supervision systems are not Perfect, uncoordinated, inadequate supervision, and not strict accountability; insufficient due diligence of intermediaries, deviations in financial audit and credit rating; excessive incentives and high salaries of financial institutions, which can easily stimulate managers to take risks and pursue profits; for financial institutions and the financial sector Insufficient understanding of the problem contagion and the systemic risks that may arise, and weak monitoring and management. I think that if the government, lenders, and financial institutions have a certain understanding of the probability of default, this will minimize the probability of default.

Answer 1

1) The reason for lack of understanding probability is "overconfidence" that the sub-prime borrowers will pay the interest on time regularly for the credit period provided to them. Along with this major reason the "securitization" that helps banks to sell the bundle to loans to other banks as stated lead to collapse of entire financial system in US as fall of one lead to fall of other. It didn't take a short period for the bubble of sub-crime crisis to burst. If the financial institutions involved in this crisis would have taken timely action in advance, the entire economy need not suffer that time with huge losses. The rising probability of losses could be a strong alarm for the financial institutions and lending could be lowered or stopped for this borrowers of low credit rating. Sub-prime borrowers started defaulting and the banks had to come out in the market to sell. Therefore, the housing rates went down due to overflow of sale of houses in the economy and banks started suffering losses. Couldn't this be predicted by a very strong economy as US and its strong financial support system. The strong loss to the economy could be avoided by due diligence.

2) The probability of default would have been definitely known to government, lenders and financial sector. The only problem was ignorance from their side. Proper attention and cognizance while granting loans would have definitely reduced the losses and probably would have eliminated them. Even if the loans were granted to sub-prime borrowers, the realisation was very late. The parties involved in this crisis should have opened their eyes on time and would have stopped granting loans to these borrowers with low credit score to escape from huge losses incurred in the economy. The intensity of problem increased due to ignorance by all the parties involved including the banks who were selling bundles of loans to other parties. So, everyone was draged in the crisis. The hedging by selling bundles was not properly strategised and implemented. Timely actions by government and financial institutions would have stopped the massive effect of these losses to the economy.