Financial Risk Manager Part 1

Explanation

The correct answer is C because it accurately captures the misaligned incentives that contributed to the 2007/2008 financial crisis:

• Mortgage originators were incentivized to issue as many loans as possible, often overlooking creditworthiness and loan quality in pursuit of volume
• Credit rating agencies, being paid by the issuers of securities (the banks), had an incentive to provide optimistic ratings to retain business from these issuers

Why the other options are incorrect:

A is incorrect because it presents an ideal scenario that didn't exist. In reality, mortgage originators often overlooked loan quality in favor of volume, and investment banks created asset-backed securities from these risky loans.

B is incorrect because credit rating agencies did not consistently provide conservative and accurate ratings. Their payment structure created conflicts of interest that led to over-optimistic ratings.

D is incorrect because many investors were actually heavily reliant on ratings from credit rating agencies and often did not perform extensive independent risk assessments, especially given the complexity of these financial products.

This misalignment of incentives created a system where quantity was prioritized over quality, and conflicts of interest compromised the integrity of risk assessments, ultimately contributing to the financial crisis.