Case Write-ups : Executive Pay and the Credit Crisis of 2008 - What incentive mechanisms are in part responsible for the financial crisis of 2008?
a. Within investment banks?
By 2005, most large investment firms had started to issue their own "private label" mortgage-based securities (MBSs) that lacked transparency. In the situation, Investment banks created trusts, which held the title to packages of mortgages and distributed the interest, principal, and other payments from borrowers to different classes or tranches of bonds held by the trust. Therefore, the world's surplus cash funneled directly into the U.S housing market, and originators were able to spread their risks among buyers around the world.
Also, investment banks paid ratings agencies to assess the risk of the tranches of bonds. It means that the rating agencies assessed each tranche separately on the tranche's payment distribution priority. All MBSs-subprime or prime-were rated highly, since the tranches were geographically diverse.
So, while some areas of the country would experience a downturn at a given time, a simultaneous nationwide deterioration in housing prices would be highly unlikely. b. Within lenders? The funds that increased liquidity for real estate caused lenders to aggressively market to potential home buyers, even those with doubtful or no credit. This in turn caused the proliferation of subprime lending. By 2006, most large investment houses had acquired subprime lenders. Subprime mortgage brokers in general sold loans with higher interest rates than traditional prime mortgages, interest only payments, balloon payments, and adjustable rates, requiring little or no money down and limited documentation. In some companies, they were compensated on the volume of loans processed rather than on the quality of those loans. These activities also facilitate the bubble of subprime. c. Within government (sponsored) agencies?
As banks made loans to qualified home buyers (the...