Role of Psychology in the financial crisis of 2007-2008

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This Subject interests me and hence i thought of putting this blog here.

Psychology played a critical role in explaining the “irrational behavior” of various financial institution entities which might have led to the subprime crisis of 2007-2008. this is a summary written on original  paper  by Nicholas Barberis.

Surge in the housing Prices:

The growth of the bubble can be attributed to the belief based theory of overvaluation where investors extrapolate past outcomes. Here in this case, the prior growth in housing price made the buyers believe that the growth will continue and bought houses with excessive loan to asset value ratio. Similarly, the financiers believed in the housing prices growth story and provided oversupply of subprime loans to buyers. These loans were securitized by complex financial innovations and sold to investors.  Here, this belief theory of extrapolation had its greatest impact where the security rating agency awarded risky assets with higher secure ratings. All this contributed to the surge in the asset prices.

Large Positions held by Banks in Sub Prime Linked Securities:

Manipulation of beliefs played a critical role in thwarting the cognitive dissonance which the various players (mortgage officials) would have felt while exposing the financial institutions to the high risked subprime linked assets. The complexity of the financial structure of these assets enabled them to manipulate their thought process through “bad incentives” - where they were incentivized to go for high growth funds and “bad models”  - where they modeled the financial future outflow to be a high growth one  and ignored the riskiness of the assets. Similar logic can be attributed to the security agencies which also gave higher ratings to these risky assets. Manipulation of belief ensured than Bank had great exposure to Sub Prime Linked Securities.

Dramatic Decline in the asset value:

With all confusion around the surprising and confusing developments in the market for subprime-linked securities, Investors including banks felt less competent while analyzing the subprime related assets as they incurred the initial losses in the risky assets.  This made them more ambiguity averse, leading them to reduce their holdings of risky assets, thereby further lowering the prices of these assets. Also the loss aversion amongst the investor increased as they incurred the initial losses which made them sell off the risky assets starting a downward spiral of asset values.

Belief based theories like Over Extrapolation over past experiences, Manipulation of beliefs to thwart cognitive dissonance and Ambiguity and Loss Aversions played a critical part in explaining all the 3 stages of the financial crisis – Surge in the housing prices, large positions held by Banks in subprime Linked Securities and Dramatic Decline in the asset values.

 Do let me know your thoughts on this.