Week 10

Question 1

How did real estate bubbles contribute to the global 2007-09 financial crisis?

Answer 1

• Real estate bubble occurred where house prices rose above fundamental values, up to unsustainably high levels by 2006 –> bubble burst, triggering widespread defaults on subprime loans –> dragged down value of banks’ subprime-linked holdings, and setting off mass withdrawals of liquid cash from banks (run on banking system).

Question 2

How did the real estate bubble caused by representativeness explain the global financial crisis of 2007-09?

Answer 2

• Representativeness by home buyers, banks & rating agencies over-extrapolating past growth in house prices.
• Home buyers overpaid for new homes & took out mortgages w excessively high loan-to-value ratios due to forecasting future house prices to also be high –> believed they could profit from future house price increases & that higher value of house collateral could quickly offset debt from mortgages.
• Banks oversupplied credit to home buyers mostly in form of subprime mortgages given to uncreditworthy borrowers, used to manufacture securities w AAA ratings through process of securitization –> believed that higher house prices could quickly offset even uncreditworthy borrowers’ debt & that loans were unlikely to default.
• Rating agencies over-extrapolated past growth in home prices, hence underestimating level of future subprime defaults –> gave AAA ratings to securities that did deserve them.

Question 3

How did cognitive dissonance explain the global financial crisis of 2007-09?

Answer 3

• Explains why banks took on large exposures to subprime mortgages & related securities in spite of the risks & why rating agencies give AAA ratings to products.
• Cognitive dissonance: discomfort people feel when they take action that conflicts w their typically +ve self-image –> to remove feeling of discomfort, people manipulate their beliefs by telling themselves that business model not risky.
• Giving a AAA rating to a product that does not deserve one would make it difficult for credit rating analyst to maintain a +ve self-image –> analyst reacts to uncomfortable feeling of dissonance by manipulating his beliefs, telling themselves that product is not that risky & deserving of AAA rating.

Question 4

How did psychological amplification explain the global financial crisis of 2007-09?

Answer 4

• Psych factors (loss aversion & ambiguity aversion) amplified decline in asset prices in crisis by encouraging investors to reduce risky asset holdings after suffering losses from them.
• Loss Aversion –> Thaler & Johnson show that experiencing a loss subsequently increases loss aversion, w people refusing to take gambles that they would take in absence of prior loss –> initial price declines forced many investors to endure painful losses, increasing loss aversion & leading them to reduce their risky asset holdings –> causing further price declines.
  *Ambiguity Aversion –> notion that people averse to outcomes w unknown probabilities –> Heath & Tversky propose ”competence hypothesis” that an individual ambiguity averse if they do not feel competent at analyzing some situations –> ”competence” refers to how much person feels they knows about a situation relative to what could be known i.e. feel less competent at asset analysis after suffering initial losses in risky asset holdings –> makes them more ambiguity averse, leading them to reduce their holdings of risky assets –> further lowering prices of these assets.