The financial crisis of 2007-2008 had severe impacts on
both financial markets as well as the real economy. Thus, an explanation of the
reasons that caused this crisis is of great importance. Behavioural finance is
a field that can provide as with insightful information regarding the
psychological reasoning behind the behaviour of agents of the economy.
The creation of a bubble or the overvaluation of an asset
can be explained by theories based on investor beliefs or investor preferences.
Regarding the investor beliefs, there are three theories:
- 1. Assets
are becoming overvalued because there is a big divergence between the bullish
and bearish investors and there are short-sale constraints.
- 2. Assets
are becoming overvalued because people are overconfident and overestimate the
reliability of their analysis.
- 3. Representative
heuristic: Bubbles are formulated because of the tendency investors have to
extrapolate past outcomes too far into the future. According to this heuristic,
investors make inferences for the population having analysed only a small
sample of data.
In addition, there are two theories from the investor
preferences perspective:
- 1. A
bubble is created because investors that experienced gains on an asset become
less risk averse; any future losses will be covered by the prior gains.
- 2. Bubbles
in new technology stocks are more likely to occur because the human brain
overweights low probabilities.
The recent real estate bubble is more likely to be
explained by the representative heuristic approach. This is because home buyers
based their decision to buy a new house on past returns of the real estate
market. This has found people buying overvalued houses with high
“loan-to-value” ratios.
However households’ over-extrapolation is only one part
of the story. One could argue that the over-supply of credit, in the form of
sub-prime loans, to home buyers has also contributed in the formation of the
housing bubble. This oversupply of credit has been the effect of the over-extrapolation
on behalf of rating agencies’ analysts. As analysts were trying to convince
themselves that house prices will continue to rise, they were giving AAA rating
to sub-prime securities implying that the risk involved in those securities was
minimal. This was greatly appreciated by investors who were fascinated about
those securities. This practise led to easy access to credit which as we have
already mentioned, pushed the real estate prices up.
Furthermore, the huge amounts of sub-prime loans and
securities held by banks had as a consequence, the real estate bubble
influencing not just individual investors but also the whole banking system. But
why had banks been holding large amounts of those securities?
Banks may had held those securities for two reasons:
either because they were doing the securitisation and they had to hold them
until the process was over and/or these securities were offering a high return
so why shouldn't they benefit from holding such securities? Nevertheless, the
risk that those securities contained has not been taken into consideration.
The answer is simple; they could hold such securities for
operational or speculative reasons but what about the risk they were exposed? Three
explanations are being provided: The banks had large positions in sub-prime
securities because of “bad incentives”, using “bad models” or simply “bad
luck”.
Of course it is difficult to believe that banks base
their decisions on luck or that they use bad models. But even the bad
incentives approach does not seem to be plausible. This is because of the basic
idea that people do not care about money but they also want to feel good about
themselves.
An alternative hypothesis is that traders on mortgage desks
were little aware of the risks and they manipulated their beliefs so that they
think their actions were not posing anyone in risk. From a psychological
perspective people manipulated their beliefs when their positive self-image is
threatened.
The reason that real estate bubble drifted the prices of
other risky assets classes down is more straight-forward. One explanation is
that banks were holding sub-prime securities which have been declining in value
and they had to sell other securities to meet margin requirements and
deleverage, forcing the prices of other risky assets down.
The psychological view is related to loss and ambiguity
aversion. There was an increase in both loss and ambiguity aversion for
investors who experienced losses from their risky asset holdings, which drove
the prices of those assets even lower. Investors found themselves in a
situation where they were thinking they are less competent which led to
increases in their ambiguity aversion.
