Biology Forums - Study Force

In this clip from The Big Short, MBS skeptic Steve Correl goes to credit rating agency Standard and Poors to see how they rate the securities based on the mortgage market.

https://www.youtube.com/watch?v=9xZx1lf2tvs

In preparation for Monday's class, explain how the incentive structure in the credit rating industry resulted in widespread mistakes in the rating of mortgage risk.

The incentive mechanisms which were responsible for the financial crisis of 2008 were:

1) Growing investors interest to invest in the US housing market which could give them low risk but high return. They started to invest more in mortgage backed securities i.e the mortages which the home owner gives to the lenders and the lenders in turn sold these to the investment banks who sold these mortgages to the investors.

2) The credit rating agencies gave these mortgage backed securities very good ratings telling the investors that it was a safe investment. The rating agencies were paid by the investment banks to give good ratings.

3) Investment banks also combined all sorts of mortgages and loans to complex derivatives called Collateralized Debt Obligation (CDO).

4) This lead the investors to invest more in the US housing market, so the increased demand made banks started to give riskier loans to the borrowers which are known as subprime loans. This lead the demand for the housing market to rise, so the price of the house also started to rise. The rising house prices made the mortgage backed securities and the Collateralized Debt Obligation more attractive to investors.

The borrowers soon started defaulting on the high prices of the house and then the supply of houses for selling went up and the demand for buying the house went down and so the prices of the house began falling. The default rate went so high that bad loans increased and many banks declared bankruptcy. The investors also began to make huge losses on their investments. This was how the financial crisis of 2008 occurred.