Recently Behavioural Economists have increasingly challenged the classic efficient market hypothesis with theories based on human psychology to explain short-term swings. This Extended Project will be exploring the extent to which psychological factors have affected the 2008 financial crisis. This paper is broken down into financial and psychological factors. Traditional Economists argue that the 2008 financial crisis was a result of purely financial factors such as Interest rates, Financial innovation and the uptick rule. New age Behavioural Economics argue that human psychological factors such as overexploitation, shortage illusion and herd behaviour were significant contributing factors. There are also Economics who argue that the financial crisis was caused by a combination of Financial and Psychological factors.
I believe that in the run-up to 2008 there were definitely significant financial threats to the economic system but the effects of these factors were severely exacerbated by human psychological factors. I also argue that some, but not all, of the fundamental financial factors, were at least partially caused by human psychology. I conclude that changes in the federal interest rate combined with over-extrapolation were the primary causes of the 2008 financial crisis because most of the other financial and psychological factors acted in reaction to the effects of it. While herd behaviour and shortage illusion were the primary psychological factors the contributed to the magnitude to the crisis.
Introduction
The 2008 financial crisis was the largest and most significant financial catastrophe since the Great Depression of 1929. According to the U.S. Treasury, $19.2 trillion was lost in U.S. household wealth (2011 dollars) after the financial collapse of 2008. $19.2 trillion is so staggeringly large that with that sum you could give every person in America $59,461.13 in cash. $19.2 trillion is 135% the size of the entire country’s 2008 GDP. Between June 2007 and November 2008, Americans lost an estimated average of more than a quarter of their collective net worth. By early November 2008 the S&P 500, seen as a bellwether for the American economy, was down 45% from its 2007 high. After such a catastrophic crisis such as 2008, it is natural to wonder what could possibly have caused this and whether these factors were fundamentally financial or a consequence of inherent human psychology. I chose this topic because I am intrigued with how people make decisions, especially when they deviate from rationality. I am currently studying A Level Economics which has provided a base on which to build my financial knowledge. My interest in investing and the stock market also pushed my Extended Project towards the financial sector. Value investing is an investment philosophy based on the idea of an inefficient stock market that is influenced by emotion and knee-jerk reactions in the short term. The central idea to value investing is that the stock market is irrational and emotional in the short term, but over the long term stock prices will tend towards their intrinsic value. I intend to study finance and behavioural economics at university so it makes sense that this project combines these two topics.
The following are definitions of some of the key technical terms that are used in this extended project. The following is intended to act as a reference.
- Homo Economicus – the concept in many economic theories portraying humans as consistently rational and narrowly self-interested agents who pursue their subjectively-defined ends optimally. homo economicus attempts to maximize utility as a consumer and profit as a producer.
- Financial crisis – a sharp, brief, ultracyclical deterioration of all or most of a group of financial indicators – short-term interest rates, asset (stock, real estate, land) prices, commercial insolvencies and failures of financial institutions”.
- Government-sponsored enterprise – quasi-governmental entities that were established to enhance the flow of credit to specific sectors of the American economy. These agencies, though privately-held, provide public financial services. For example, Federal Home Loan Mortgage Corporation (Freddie Mac) was originally created as a GSE in the housing sector to encourage homeownership among the middle class and working class. Other mortgage GSEs, as they are called, include Federal National Mortgage Association (Fannie Mae) and Government National Mortgage Association (Ginnie Mae) which were introduced to improve the flow of credit in the housing economy, while also reducing the cost of that credit.
- Default – The failure to pay interest or principal on a loan or security when due. Default occurs when a debtor is unable to meet the legal obligation of debt repayment.
- Foreclosure – the legal process by which a lender takes control of a property, evicts the homeowner and sells the home after a homeowner is unable to make full principal and interest payments on his or her mortgage, as stipulated in the mortgage contract.
- A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. This security must also be grouped in one of the top two ratings as determined by an accredited credit rating agency, and usually pays periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution.
- Collateralized Debt Obligation (CDO) – a structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. A collateralized debt obligation is named for the pooled assets — such as mortgages, bonds and loans — that are essentially debt obligations that serve as collateral for the CDO. The tranches in a CDO vary substantially in their risk profiles. The senior tranches are generally safer because they have first priority on payback from the collateral in the event of default. As a result, the senior tranches of a CDO generally have a higher credit rating and offer lower coupon rates than the junior tranches, which offer higher coupon rates to compensate for their higher default risk.
- Bubble – an episode in which irrational thinking or a friction causes the price of an asset to rise to a level that is higher than it would be in the absence of the friction or the irrationality; and, moreover, the price level is such that a rational observer, armed with all available information, would forecast a low long-term return on the asset.
- Solvency – is the ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business as it asserts a company’s ability to continue operations into the foreseeable future. While a company also needs liquidity to thrive, liquidity should not be confused with solvency. A company that is insolvent must often enter bankruptcy.
- Naked shorting is the illegal practice of short selling shares that have not been affirmatively determined to exist. Ordinarily, traders must borrow a stock, or determine that it can be borrowed, before they sell it short. Due to various loopholes in the rules, and discrepancies between paper and electronic trading systems, naked shorting continues to happen.
- The SEC (Securities Exchange Commision) is an independent federal government agency responsible for protecting investors, maintaining fair and orderly functioning of securities markets and facilitating capital formation.
Literature Review
Introduction
This literature review will briefly outline the theories and ideas that contribute to the causation/creation of financial crises. These theories can be categorised thematically into financial factors and psychological factors. Financial factors consist of theories relating to the structure and governance of the financial system, while psychological factors encompass ideas relating to the bounds of rationality of economic agents, and how economic decisions made by these agents deviate from Homo Economicus, the imaginary person that economists use to model human behaviour, who has the infinite ability to make rational and selfish economic decisions. The traditional consensus among economists is that financial crises are caused solely by fundamental financial factors such as changing interest rates, the deregulation of the financial industry and the government initiative to artificially promote home ownership to blame, however this viewpoint has in recent years been challenged by the relatively new field of behavioural economics who argue that psychological elements such as social and emotional factors have a significant effect in causing people to deviate from a purely rational psychology.
For clarification, a financial crisis is any situation in which some financial assets suddenly lose a large part of their nominal value. Types of financial crises include stock market crashes, real estate crashes, banking crises and currency crises.
Traditional financial factors
In this section of the literature review I will present the main financial factors that caused the 2008 financial crisis.
Interest rates
A Financial crisis can sometimes be caused by sudden changes in interest rates. For example in the aftermath of the 2001 dot com bubble the federal reserve, under Alan Greenspan, lowered short-term interest rates to record low levels of 1%. In fact, interest rates were below inflation for just under 3 years. This means that interest rates were so low that banks were actually losing money on these loans (in real terms). This made it incredibly attractive to borrow money because the payments needed to service these loans are very low. What happens when you hold interest rates down like this is that you cause people to make decisions that they wouldn’t usually make. This is because the level of interest rates is the most important factor that people consider when taking out a loan. Alan Greenspan pushed interest rates down like this gave people a green light to make a purchase that they wouldn’t have made otherwise. For example, when buying a house, people would buy a bigger and nicer house, in a better area that they wouldn’t otherwise be able to afford. Furthermore, bankers, following the same train of thought, increased their leverage in order to take advantage of the cheap capital and increase returns. In addition, the low-interest rates forced investors out of traditional government and treasury bonds and into more risky investments such as mortgage-backed securities and derivatives that had the potential to provide higher returns. The graph below shows the Effective Federal Funds Rate which is what short-term interest rates are based on, which are the rates charged on everything from mortgages to automobile loans to credit card payments.
Figure 1
Effective Federal Funds Rate
As a result of the recent appreciation in house prices and the fact that real estate had traditionally been considered a ‘safe bet’, the housing market boomed growing 12% compounded annually from 2000 to 2007. This was a very attractive proposition for many homebuyers as they could take out a loan at 1% and buy a house that was appreciating at 12%, all with virtually no risk as if the homeowner defaulted on his or her loan then house simply acts as collateral. Furthermore, an element of speculation was introduced to the market as people would prematurely buy houses that they otherwise would not have been able to afford with the intention of selling it on for a higher price in the future. This point ties into over-extrapolation which I shall touch on in the psychology section of this literature review.
Figure 2
U.S National Home Price Index
The reason why this was so catastrophic was that in July of 2004 the Federal Reserve started raising interest rates rapidly up to a maximum of 6.25% 2 years later. As a result, people with variable rate mortgages or Adjustable rate mortgages where the monthly payments fluctuate based on the interest rate will have faced drastically higher monthly payments. Consequently, many people were forced to default on their loans. The default rate on subprime adjustable rate mortgages increased from 5% in 2005 to 43% in late 2009 as shown from the graph below. Suddenly demand for houses plummeted as these great deals on mortgages courtesy of rock-bottom interest rates were no longer available. Furthermore, when people default on their mortgages their house is seized by the bank as collateral, the banks would then sell the house on the market in order to compensate for their loss. This increased the supply of houses on the market. This flood of new property onto the market increased supply and thus the hike in interest rates acted as a double-edged sword and caused house prices to plummet across the country.
As per our definition this drop in house prices already constituted a financial crisis, however now this literature review shall now examine how this contained fall in asset prices causes the worst financial crisis since the 1930’s. Essentially banks had very high exposure to subprime mortgages as a result of large highly leveraged positions in Mortgage Backed Securities. When the housing market collapsed in 2008 these Mortgage Backed Securities became almost worthless and the banks lost billions of dollars. This caused bank capital to shrink preventing them from making loans. This also caused a widespread loss of confidence in the creditworthiness of banks which triggered a classic run on the bank where people did not want to do business with the banks anymore in fear that their capital would not be paid back. This essentially froze up the economy as the banks were unable to make loans to businesses which are essential for growth and expansion. In summary low-interest rates caused consumers to buy lots of things they wouldn’t buy normally and the sharp hike that followed caused many people to no longer afford these goods.
Government initiative to promote home ownership
Whether or not government initiatives to promote home ownership caused the financial crisis of 2008 is disputed between the sides of the political spectrum. On one hand conservatives have claimed that the financial crisis was caused by too much regulation aimed at increasing home ownership rates for lower income people. While liberals would argue that Government-Sponsored Enterprise loans were less risky and performed better than loans securitized by more lightly regulated Wall Street banks.
Some people would argue that one of the main factors of the 2008 financial crisis was the government effort to support and introduce liberal housing and lending policies that resulted in the collapse of loan underwriting standards. Joseph Fried, author of “Who Really Drove the Economy Into the Ditch?” argues it was inevitable that the looser lending standards would become widespread: “…it was impossible to loosen underwriting standards for people with marginal credit while maintaining rigorous standards for people with good credit histories. Affordable housing policies led to a degrading of underwriting standards for loans of all sizes.” In reality, these government initiatives led to the weakening of mortgage underwriting standards for most residential loans in the US, thus dramatically increasing the risk of default and foreclosure in the mortgage market.
Financial innovation – securitization
Academics such as Kühnhausen (2014) have argued that financial innovation was one of the primary causes of the 2008 financial crisis. In particular, the securitization of mortgages in the form of Mortgage Backed Securities and the introduction of financial products such as Collateralized Debt Obligations. Furthermore, Crotty (2009) points to the ‘highly bonus driven’ culture common at investment banks. The flaw in this system is that employees are compensated based on the quantity and not the quality of their work and therefore are financial encourage to sell as many of these newfangled Mortgage Backed Securities as humanly possible. In this manner, bankers would take on a higher level of risk for his or her bank, which is not necessarily in the best intentions of the firm, in order to increase their own compensation.
Furthermore, asymmetric information as a result of the complexity of these new financial product allowed the sellers of these products to offload them at higher than intrinsic value by hiding or understanding inherent risks to the asset such as the true risk of default. In addition, Asset managers were pushed away from traditional municipal and treasury bonds which now had low yields as a result of low interest rates and towards these new and exciting securities that promised higher returns than government bonds.
Rating agencies
Credit rating agencies are firms that rate debt securities by the debtor’s ability to repay the principal and interest owed on the loan. Rating agencies were crucial to the asset management industry as these Mortgage Backed Securities could not be sold to many money market and pension funds, a large chunk of the investment market, without the a ‘triple a rating’ from one of the ‘big three’ rating agencies: Moody’s Investors Service, Standard and Poor’s and Fitch ratings. This was due to the regulation made by these funds restricting the purchase and holding of assets to the safest rating, ‘triple-A’. These rating agencies wrongly gave triple-A ratings to billions of dollars worth of Mortgage Backed Securities. These ratings are used by investors for screening securities and as a guideline for riskiness, thus these agencies caused the distribution and sale of Mortgage Backed Securities and other Collateralized Debt Obligations to be grossly overbought.
The fundamental structural flaw that caused this fraudulent false rating of securities was that rating agencies collected a fee for each rating they issued. Therefore rating agencies had financial compensation to retain as much business as possible. If a banks requested a rating from an agency for their new financial product and they received a sub triple-A rating that truly reflected the quality of the security the bank, unsatisfied, could go next door to one of the other agencies and receive a triple-A, while the original rating agency just lost a significant fee to one of its competitors. As a result of this, the rating agencies were pressured into giving inflated ratings to new securities that had recently been securitised as a result of financial innovation.
Rule 201 (“The uptick rule)
Rule 201, also known as the ‘uptick rule’ was a rule first implemented by the Securities Exchange Commision in 1938. Essentially the rule required every short sale of a stock to be entered into at a higher price than the previous trade. The rule was introduced in the aftermath of the Great Depression by the Securities Exchange Act of 1934 with the intention of ensuring the stability of the stock market, by preventing short sellers from aggravating the downward momentum in a stock that was already declining.
The rule was repealed by the Securities Exchange Commision on the 6th of July, 2007 and some argue that this action contributed the financial crisis because of the ‘bear raid’ on many of the large investment banks such as City group. A bear raid is when a group of traders try to force the price of a stock down in order to profit from short positions. This is done by the spreading of rumours about a company’s future, its management or anything else that was likely to cause a bearish sentiment. Evidence of a bear raid on City group can be shown on November 1, 2007, when Citigroup experienced an unusual increase in trading volume and decrease in price. The decline in price was due to a vast increase in the selling of borrowed shares which cannot be explained by news events or new City group earnings reports as there was no corresponding increase in selling of regular ‘long’ shares. This is an illegal activity where high-value investors force down the price of a stock by collectively shorting high volumes of shares in an effort to make a profit from the artificially lower price.
Psychological factors
Here this literature review will present the primary psychological factors that cause financial crises.
Bank run
A bank run occurs when a large number of people withdraw their money from a bank because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system (where banks normally only keep a small proportion of their assets as cash), a large number of customers withdraw cash from their accounts with a financial institution at the same time because they believe that the financial institution is, or might become, insolvent; and keep the cash or transfer it into other assets. When they transfer funds to another institution it may be characterised as a capital flight. As a bank run progresses, it generates its own momentum: as more people withdraw cash, the likelihood of default increases, triggering further withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy. To combat a bank run, a bank may limit how much cash each customer may withdraw, suspend withdrawals altogether, or promptly acquire more cash from other banks or from the central bank, besides other measures. Humans have a high propensity to loss aversion and as a consequence are very nervous about where they keep their money. The slightest sign of trouble can cause billions of dollars to be withdrawn from a bank.
Representativeness / overexploitation
On the psychological side of things representativeness or overexploitation can be used to explain the formation of speculative bubbles. The theory is that, investors extrapolate past events, that act as investment indicators, too far into the future. This assumption is usually motivated by Kahneman and Tversky’s (1974) representativeness heuristic. A heuristic is a problem-solving method that uses mental shortcuts to produce rough solutions given limited time or mental resources. According to this heuristic, people expect even small samples of data to reflect the properties of the parent population. As a result, they draw overly strong inferences from these small samples, and this can lead to over- extrapolation.
In relation to 2008 – we can apply this theory to home buyers and say that, when forecasting the future growth in house prices, they over-extrapolated the past growth in these prices. This led them to overpay for their new homes and to take out loans with excessively high loan-to-value ratios. Banks and investors were also over-extrapolating the default rate on mortgages as they financed and purchased Mortgage Backed Securities. This inflated the demand for mortgages and as a consequence led to lenders decreasing loan standards in order to make more loans to people of various financial situations.
This can be represented by the following chain of events: Homeowners and Banks over-extrapolate past house price growth -> Oversupply of credit to homeowners (subprime loans) -> securitization of mortgages -> Investors too enthusiastic about mortgage-backed securities as they also over extrapolate past returns and many of them were given AAA ratings which were not deserved.
Representativeness may have contributed to the issuance of undeserved triple-A rating to new Mortgage Backed Securities as the big three rating agencies could have over-extrapolated the past growth in house prices into the future. As a result of this rating agencies misjudged the default level of future subprime mortgages. It would have been particularly easy for the employees of the rating agencies to fall for the representativeness heuristic as they wanted to believe that house prices would continue to rise in the future. Furthermore, the complexity of these new financial products would have made the rating firms more susceptible to over-extrapolation as it avoided much of the work that it would otherwise have done to thoroughly analyse the mortgages that composed the securities and thus uncover the true associated riskiness that should be reflected in the rating.
Therefore overexploitation by multiple parties in the economy contributed to the financial crisis of 2008.
Innovation
Bubbles are particularly likely to occur in stocks related to a new technology. The reason is that investors view these stocks as lottery-like: should the new technology deliver on its early promise, some of the stocks may experience huge increases in value. Given that many people have a strong preference for lottery-like payoffs – perhaps because, as Kahneman and Tversky (1979) argue, the brain overweights low probabilities and therefore they may overvalue these stocks. This theory is particularly useful in explaining the 2001 dot-com bubble where the rise of the internet introduced newfangled technology stocks with obscure products were bid up to astronomical valuation far beyond any rational measurement of intrinsic value. Furthermore, it could be argued that the Great Depression of 1929 was also caused by technological advances such as the introduction of the railroad and the agricultural developments such as the invention of the tractor.
Shortage illusion
The shortage illusion in any market is that price changes will not tend to restore equilibrium in the market. Shortages are seen as continuing indefinitely, and perhaps also price increases are seen as continuing indefinitely, so that observing excess demand may help to reinforce a boom. It seems that the popular model takes shortages or surpluses as reflecting absolute supply and demand, rather than supply and demand at a given price. Disequilibrium is not seen at all as a reflection of a barrier to price adjustment.
An example of this would be how at theaters or music concerts, tickets are often An example of this would be how at theatres or music concerts, tickets are often intentionally priced under market equilibrium level in order to ensure that the tickets sell out and that the stadium or theatre is full. This is due to the fact the human brain associates empty seats with a poor performance. Furthermore when tickets sell out demand actually increases as people line up to get tickets which attracts more people who see shortages as continuing indefinitely. Furthermore, there is the idea that others demand the good, thus if you don’t act now you’ll miss out on the good that contributes to the increase in demand. This leads into the fear of missing out function which is characterised as the “pervasive apprehension that others might be having rewarding experiences from which one is absent. It is characterized by the “desire to stay continually connected with what others are doing.” The bottom line is that if something is rare or unattainable we want it more.
For example, if 20 ten year olds compete in a race and medals are only given to the children that come in first, second and third then these medals will be highly coveted and meaningful. However, if everybody gets the same medal regardless of performance the medals become worthless as they are not scarce. This is exactly the same concept as how the printing of money devalues the currency. Money has no intrinsic value it only has the value that we place on it as a result of its scarcity.
Strategic complementaries / self-fulfilling prophecy
Self-fulfilling crisis refers to a situation that a financial crisis is not directly caused by the unhealthy economic fundamental conditions or improper government policies, but a consequence of pessimistic expectations of investors. In other words, investors’ fear of the crisis makes the crisis inevitable, which justifies their initial expectations.
Herd behaviour
The classic theory of such herding behaviour is found in The general theory of employment, interest and money by John Maynard Keynes (1936: 154-7), in which he made a comparison of the stock market with a beauty contest. According to him, the behaviour of investors is like newspaper beauty contests in which readers are asked to choose the six prettiest faces from a hundred photographs. When the winner is to be the person whose choice was closest to the average preferences of the total participants, people would choose those that they think the others would fancy, not those that they think the prettiest.
Prospect theory
According to Kahneman and Tversky (1979), people tend to behave as if they regard extremely improbable events as impossible and extremely probable events as certain. To apply this function to the 2008 financial crisis investors underestimate the magnitude of the future default rate as a dramatic increase was in their mind unlikely. In addition, a lender may have taken on the same frame of mind when issuing subprime mortgages.
Another feature of prospect theory is loss aversion. This is the theory that states that the magnitude of the pain from losing a set amount of money is double the joy gained from gaining the same amount of money. This idea can be used to explain why investors often rush to sell assets when the price falls. This can create a vicious cycle that can transform small market corrections into full-blown crashes. This can be used to explain the extent of the stock market correction during the crisis. Furthermore, the pain suffered from taking a loss is so great that people are often willing to take on more risk in order to avoid releasing a loss. An example of this would be a gambler at a casino who has been on a losing streak and goes all in at the poker table in order to avoid going home with less money than he came with. This is irrational behaviour because past results should not influence future strategy as the probability of winning each round of gambling is independent of the previous rounds.
Consider the following questions:
Q1. Which would you choose?
Lottery A that offers a 25% chance of winning £3,000
Lottery B that offers a 20% chance of winning £4,000
Q2. Which would you choose?
Lottery C that offers a 100% chance of winning £3,000
Lottery D that offers an 80% chance of winning £4,000
Q3. Which would you choose?
Lottery A that includes a 25% chance of losing £3,000
Lottery B that includes a 20% chance of losing £4,000
Q4. Which would you choose?
Lottery C that includes a 100% chance of losing £3,000
Lottery D that includes an 80% chance of losing £4,000
The interesting part of this experiment, conducted by Kahneman and Tversky (1979), is that questions 1 and 2 are fundamentally the same apart from the fact that the probabilities of question 2 have been multiplied by a factor of 4. Therefore if one is rational they will choose A and C or B and D. Otherwise they are changing their answer to the same question.
Results
Q1
Q2
Results
A
B
C
D
Q1 and Q2 (Positive prospects)
35%
65%
80%
20%
Q3
Q4
(Negative prospects)
42%
58%
8%
92%
The positive prospect results show a clear preference for a certain outcome as both questions are the same and the majority changes from answer choice B for question 1 to answer choice C for question 2. This show irrational behaviour because as Homo Economicus would pick one answer and stick to it.
These results illustrate the point that people are willing to take on greater risk rather than lock in a loss in the form of certain 100% probability. The vast majority of subjects would rather have an 80% chance of losing £4000 despite the fairly equal distribution of answers in question 1. In addition answers B and D have higher expected losses as calculated by the equation: expected outcome = outcome x probability and therefore are essentially the ‘wrong’ answers.
Discussion Section
Statement of your point of view
In my opinion, there were fundamental financial factors that ‘caused’ the financial crisis however the effects were highly aggravated by psychological factors. I would also argue that some of the fundamental financial factors were caused or aggravated by psychological factors. Thus if there was an alternate universe where we could run the events again replacing regular humans with Homo Eonomociscus, who have an infinite capacity to make rational decisions there would still have been a financial crisis however it would have been far less severe.
Financial factors
Interest rates
Alan Greenspan, the former chairman of the financial reserve, himself has stated that the housing bubble was “fundamentally engendered by the decline in real long-term interest rates”, though he also claims that long-term interest rates are beyond the control of central banks because “the market value of global long-term securities is approaching $100 trillion” and thus these and other asset markets are large enough that they “now swamp the resources of central banks”.
Academics arguing financial factors were the primary cause of the 2008 financial crisis point to the pattern of interest rate changes as the leading factor. They would point to the fact that the FED held down interest rates post dot-com bubble and then raised them suddenly and drastically in 2006. Essentially when interest rates were low amount of mortgages bought increased dramatically and when interest rates were raised the default rate on these mortgages increased dramatically. These people would argue that it was rational for Alan Greenspan to lower interest rates after the 2001 financial crash in order to jump-start the economy. However, I would counter this with the fact that the 2001 financial crisis in and of itself was the result of psychological factors that caused the stock of any company with an ‘x’ in its name that sounded vaguely high tech were bid up to extravagant multiples of earnings (if any). Thus the lowering of interest rates in the early 2000s was directly caused by psychological factors in the dot-com bubble.
Figure 1
It could be argued that increased buying activity by consumers was rational because, at the time that they took out the mortgage, they were actually offered a very good deal. The vast majority of the time they could actually afford to pay the monthly payments at the starting rate, and if they couldn’t they had almost zero risk as they could just default on their mortgage and walk away from the house with impunity (in some states). This was even less risk than a renter would take on as they can be held accountable by their landlord for violating the lease agreement. The average home buyer who stretched themselves financially to “squeeze” into a larger house in a nicer neighbourhood was actually making a very rational decision using the information available to them.
In addition, bankers borrowed more in order to take advantage of low interest rates. This is called leverage when an investor borrows money in order to increase the potential return of an investment.
In my opinion the changes in the federal interest rate was the most important factor that had the most impact of the financial crisis because the majority of the other factors, both financial and psychological were in reaction to or as a consequence of interest rates.
Naked short selling
So-called “naked” short sales are short positions for which no
underlying security has been borrowed. According to the SEC (Securities and Exchange Commission):
“In a ‘naked’ short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due; this is known as a ‘failure to deliver’ or ‘fail.’
As Lehman Brothers Holdings Inc struggled to survive in 2008, as many as 32.8 million shares in the company were sold and not delivered to buyers on time as of September 11, according to data compiled by the Securities and Exchange Commission and Bloomberg. That was a more than 57-fold increase over the prior year’s peak of 567,518 failed trades on July 30.
The SEC has linked such so-called fails-to-deliver to naked short selling, a strategy that can be used to manipulate markets. A fail-to-deliver is a trade that doesn’t settle within three days. Therefore short selling is evidence of a fundamental financial factor that had an impact on the financial crisis. “We had another word for this in Brooklyn,” said Harvey Pitt, a former SEC chairman. “The word was ‘fraud.’”
Twice during 2008, hundreds of thousands of failed trades coincided with widespread rumours about Lehman Brothers. Speculation that the company was being acquired at a discount and later that it was losing two trading partners both proved untrue.
However, in periods of market decline and financial crisis, greater regulation seems necessary to curb the impact of pessimistic rumours and doomsday speculation. In these conditions, greater regulation-or suspension-of short selling lo
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