Financial crisis of 2007-2008: A psychological perspective.

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. 1.     Assets are becoming overvalued because there is a big divergence between the bullish and bearish investors and there are short-sale constraints.
2. 2.     Assets are becoming overvalued because people are overconfident and overestimate the reliability of their analysis.
3. 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. 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. 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.