Finance-Mini Case.
Question 1.
If one party is more well-versed in the information than the other party in the negotiation process, then the adverse selection occurs. This may result in poor decision making or lead a business into realizing fewer profits or getting into way riskier deals. This is what has happened in most car insurance companies. Through the issuance of insurance policies, they have become the victims of losses to car owners. Over time, insurance companies have been forced to impose a high-risk policy on high-risk consumers. For instance, for people in high crime areas, the car insurance company charges them more.
Choosing to insure only safe drivers sounds a good idea for though it is not. This is because insurers have majored in maximizing their profits by imposing high premiums on the high-risk drivers. If the low-risk drivers choose not to drive, the insurers will be in for a considerable loss. It is thus not a wise decision for them to only insure the safe drivers only. The insurance policies should be all-inclusive, much as it is a high risk.
Question 2.
The theory of finance provides a basis for the explanation as to why banks exist. This regards the traditional and current/new view of banks. Traditionally, they were seen as financial intermediaries that helped take care of people’s financial needs, such as borrowing and saving. This is in the supply of both liquid and credit assets. The new view takes a little shift and focuses on the evaluation and assessment of borrowers. From other angles, they are also viewed as offers of transaction services and suppliers of liquidity. Through the diversification that occurs at the banks, the customers/clients have their risks reduced. The banking system is also playing a vital role in the payment of goods and services. Many organizations and businesses opt to have their pay done through the banks.
Regarding problem-solving in issues related to finances, the banks have been on the forefront. The banks have played roles related to guarantors and the general risk management roles for their customers. Through advancements such as mobile banking, automated teller machines, and internet banking, the banks have been able to ease transactions and relieved the people the hustle of queueing at the banks.
Question 3.
The subprime mortgage crisis of 2008 stemmed from the expansion of mortgage credits. The three major causes linked to this crisis are the insurance companies, banks, and hedge funds. In my view, banks played a critical role that led to this crisis as they created the mortgage-backed securities. The act of banking lending to everyone, even those who can be termed as not being able to afford loans, led to the crisis. Subprime mortgages were increased by the fact that investors demanded low premium MBS.
Through covering defaulters with credit default swaps, the insurance companies ended up playing a major role in steering the crisis. As the insurers continued to cover the people, there came a time when they realized investment losses. By shielding the swaps, the crisis emerged and continued to overshadow the market.
In addition to the factors are the hedge funds. This played a crucial role in fueling the crisis. Pressure from different stakeholders has always mounted on the hedge funds for them to outperform the market. The market standards were maintained for quite some time until the Fed interest rates started rising. This then resulted in those having adjusted mortgage rates not being able to make their payments. The securities were then rendered worthless, making the American International Group almost bankrupt. It was around this period that the subprime crisis sprang up. All three causes were instrumental in triggering the event because they have a direct influence.