Question

Prior to $2008$, mortgage lenders required a house inspection to assess a home’s value and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in $2008$, mortgage lenders required a house inspection, but this inspection was arranged through a third party. How does the pre-$2008$ scenario illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?

Short answer

Credit-rating agencies in the global financial crisis faced similar problems. Investors would purchase highly rated assets thinking that it was a safe investment, but take on more risk than expected in reality.

Step-by-step solution

Definition

Conflicts of interest arise when a person or organisation has various goals that contradict, and they are a form of moral hazard problem. This exacerbates the asymmetric information problem because conflicting incentives encourage individuals or institutions to withhold or misrepresent information.

Explanation

Mortgage lenders' goal is to extend loans to prospective homeowners. They profit from the interest collected on these loans(mortgages)so they have an incentive to loan to as many people as possible. These lenders are also supposed to screen out bad credit risks so that they are more likely to be repaid their loans. However, their incentive to profit from issuing as many mortgages as possible overshadows their concern of lending to the wrong people; this represents a conflict of interest for the mortgage lenders.

They faced similar problems. They were paid money to assess the riskiness of assets, and the more money invested in these assets, the more money they were paid. This gave the agencies incentive to rate up assets that are not as safe as they appeared rating-wise and contributed to the lack of information in the financial market.