- Financial Crisis and collapse of financial industry, moral hazard is the core of the causes.
- Securitization eliminates the incentive for the originator of the loan to be credit sensitive... With securitization, the dealer (almost) does not care as these loans can be laid off through securitization.(called a ‘‘moral’’ hazard). The originating banks replenished their funds, enabling them to issue more loans and generating transaction fees.
- Credit rating agencies having given investment-grade ratings to MBSs based on risky subprime mortgage loans. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. ( moral hazard)
o Unethical Practices and Moral Hazard
o Securitization and speculation
o Paper Currency
If we look at the core of the financial crisis, it all started with unethical practices of lenders/banks to lend the money who can not afford it. These bankers are only interested in getting processing fees and placement fees and making money on it. They bundled these entire low quality loan into securities, and sold to the market. Most importantly rating agencies rated these securities wrongly to get good rating. Then market players sold CDS and Interest rates swaps on them based on these rating. Then speculators played on these securities to generate profits.
When it comes to commodities I can say securitization of commodities market and derivatives played by the speculators are the sole reason for the high prices of commodities across the world. Derivatives are the other reason of collapse. Role of paper currency is another very important issue at the center of financial crisis. These papers currencies which do not have any weight themselves has become most important tool of the speculators, derivatives, currencies and their casino’s has played key role in financial crisis. Securitization and securities market has become the 24 hour casinos for the speculators who play on 95% barrowed money. (Commodities, currencies and derivatives)
But a crucial question remains that has not had much exposure: where were the auditors? Unqualified audit reports up to the collapse had concluded that the directors’ reports and accounts reasonably reflected reality.
Auditors have contributed to the crisis by accepting directors’ “mark-to-market” valuation of trading assets, when some basic questions would have shown them that those directors (i) hadn’t the remotest clue what was in the mortgage / loan packages they had acquired; (ii) were utterly bemused by the nature of the complex derivatives on which their asset valuation rested; and (iii) knew that there was no market to “mark” to.
Derivatives are central to the demise of Lehman. Its annual accounts mention derivatives contracts with a face value of $738bn and fair value of $36.8bn.
Flaws in rating methodologies were the major reason for underestimating the credit default risks of instruments collateralized by subprime mortgages.
The governance of credit rating agencies did not adequately address issues relating to conflicts of interests and analytical independence.