Financial Risk Manager Part 1

Explanation

Agency costs are incurred when there is a conflict of interest between two parties, often due to misaligned incentives. In the context of the 2008 financial crisis, rating agencies were paid by their clients to rate financial instruments. These agencies had a vested interest in providing favorable ratings to keep their clients happy and secure future business. This led to a situation where they overlooked potential financial risks, thereby underestimating the inherent risks in Asset-Backed Securities (ABSs) and Collateralized Debt Obligations (CDOs). By maximizing the number of AAA-rated tranches, the agencies misled investors into purchasing overvalued and overrated instruments. This is a clear example of agency cost, where the rating agencies pursued their selfish interests at the expense of the investors.

Why other options are incorrect:

• Choice A: Homeowners lying about income represents fraud, not agency costs, as homeowners were not acting as agents for another party.
• Choice B: Lack of government regulation represents regulatory failure, not agency costs between parties with conflicting interests.
• Choice D: Congressional inaction represents political or regulatory failure, not agency costs between principal-agent relationships.