Question

Explain how the credit crunch originating in the mortgage markets hurt financial intermediaries' attempts to use diversification and monitoring to limit the riskiness of their loans and investments while offering more liquid claims to savers.

Answer 1

Financial intermediaries make an attempt to diversify away from specific risk failure to which when large portion of the debt markets “seized up & stop functioning”. At this point the prices of many securities dropped regardless of the historical correlation among the security prices. This is a failure of diversification to reduce risk. They exploit diversification principles & economies of scale in order to allow the financial intermediaries to invest large amounts of money. They must also closely monitor the riskiness of their loans & securities & many financial intermediaries are regulated by the government to ensure that they manage the riskiness of their assets.

Many people also argue that the financial intermediaries failed to monitor the riskiness of many of their mortgage investments that leads to large number of poor investments.