Final answer:
Agency costs refer to the costs arising from the conflicts of interest between a company's managers and its owners. They played a role in the credit crisis when managers of financial institutions took excessive risks with investments in complex securities, driven by short-term gains rather than considering long-term stability.
Step-by-step explanation:
The term agency costs refers to the expenses incurred due to the conflicts of interest between the managers (agents) and shareholders (principals) of a corporation. These costs arise from the agency problem, where the agents may prioritize their personal interests over that of the principals, potentially leading to suboptimal decisions from an ownership perspective. This issue is especially relevant in large organizations with dispersed ownership where direct oversight by shareholders is limited.
During the credit crisis, agency costs played a significant role. Financial institutions' managers took excessive risks by investing in complex securities like collateralized mortgage obligations (CMOs) and credit default swaps (CDSs), motivated by the potential for high short-term profits and bonuses. Since their personal liability was often limited, the agency costs resulted from these managers making decisions that were ultimately detrimental to the long-term health of their organizations and the broader economy. These risky financial products were rated very safe by private credit rating agencies, which contributed to the underestimation of the actual risks involved by the investors and other stakeholders.