Question

What are some principle agent problems during the financial crash of 2007-2009? Please explain why. I will make sure to thumbs up.

Answer 1

In the financial crisis that began in 2007, the main agent issues were very real. We derive from the asymmetry of information between the agent and the principal. The issues allowed mortgage borrowers, mortgage lenders, and investment banks to maximize their profits without responsibility for mortgage risks. Their unaccountable actions lead to the proliferation throughout the financial system of a large amount of subprime mortgages. Such loans have been covered up by complex financial mechanisms and have received high ratings that make them look like a very safe investment.

It became apparent after the housing bubble burst that the costs of these bonds were far greater than the credit markets expected to crash. Most of the key agent problems in the financial crisis include the resolution of government regulations, as players are unwilling to give up lucrative opportunities. Government solutions should aim to protect the financial analphabet, hold all parties accountable for their actions and provide financial market transparency.

The type of financial institutions that demanded credit was not visible to lenders, and it was not even visible to them most of the time, as they had no idea how precarious their securitized mortgage assets were. There was no realistic chance of signalling a good type, and poor types wouldn't get any credit because they had a very high chance of defaulting. This is a very difficult problem for the principal agent to solve; since they are no way for the financial institutions to send their wellbeing a reliable signal. Alternatively, what the government can do is provide the financial institutions with large loans.

In the main-agent relationship between the financial institution and its clients and investors, this same adverse selection took place. It was very difficult for the institutions to prove that they were still in good shape, and the only thing that prevented massive bank runs and a financial system collapse was the government deposit guarantee. Investors were not so fortunate to have this protection and tried to sell their stocks on a massive scale. This caused a huge fall in stock prices for all financial institutions, including the' healthy' ones, as they were unable to signal their type.

The following steps should be taken by the U.S. government:Standardize mortgage agreements and borrower details and include a condition on loan suitability to protect lenders who are financially illiterate.
Remove non-recourse mortgages that will keep lenders responsible for their houses ' value, remove default incentives and force them to pay more attention to the financial aspect of the mortgage. Require mortgage lenders to hold a portion of each mortgage, making irresponsible mortgages unprofitable for them. Such interventions might have avoided the current form of the financial crisis, but this is easily said in retrospect. The challenge is to prevent future crises that will undoubtedly be in an unexpected area. The best way to protect yourself is to conduct extensive risk analysis, maintain a good margin for error, and always focus on your counterparties ' incentives. If they are not responsible for their actions and their data can not be confirmed, do not trade.