The price of real estate in the United States increased dramatically in the years leading up to the 2007 financial crisis. This could be explained by applying economics and fundamentals. However, when the prices continued to surge far above fair market value and create a property bubble, it became evident that the increase is driven by certain phenomena in behavioural finance.
Possible reasons why prices continued to rise past fair market value can be linked to the belief-based theory of overvaluation and overconfidence.
Investors tend to extrapolate past outcomes too far into the future, believing that prices would increase indefinitely. They also tend to be overconfident in the precision of their forecasts, thinking that if they are right predicting the initial price increase, their predictions on all future price increases would also be right.
AAA ratings makes risky safe
Similar behavioural finance explains why banks had such large positions in subprime-linked securities. The biggest reason for the large position was that rating agencies over-extrapolated too far into the future, based on all the positive news and price increases. They issued AAA ratings because they concluded that these investments were secure. The ratings gave banks the security backing to accumulate large positions, even though these investments turned out to be riskier than initially expected.
The belief manipulation worked well with subprime securitisation for two reasons. The first was the belief that AAA ratings meant that investments had to be safe. Due to the complexity of these securities, risk analyses proved very difficult. Thus the credit rating of the security had a big impact on how many of these securities banks acquired.
Secondly, the market expectation that the boom would continue indefinitely came easy on the back of house price increases. Thus the rationale behind the fundamentals was easily argued.
False sense of security
This created a false sense of security, while nobody owning the securities really understood what the risk of default was.
Banks also continued to accumulate these risky subprime loans due to bad incentives and/or bad models. Bad incentives are when a trader would be unduly influenced by financial reward at the expense of risk management. Bad models are the inability of banks to analyse and determine the risk of each security. The combination of belief manipulation and bad incentives and/or models led to traders accumulating large positions in subprime securities.
The catastrophic results of the financial crisis are well known. Financial markets were in turmoil. Risky assets saw dramatic price drops due to the domino effect through institutional amplification mechanisms.
As the first homeowners started to default on their mortgage loans, the securities started to decline in value. Banks needed to cover their losses and deleverage. They had to sell positions out of other risky assets. This forced down the price of risky assets that were in turn held with other banks, forcing these banks to sell down to cover their own losses. A run on the banks and major liquidity problems followed. The regulators had to intervene.
Behaviour determines repeat or not
The effects of the 2007 financial crisis will remain with us for many years to come. The financial markets have recovered and investors have been remunerated well for staying invested for the long term. Most market commentators expect a subdued 2014 after five-plus years of very impressive growth. The questions are whether we can forecast another bubble in asset prices, and whether there might be a correction in the market. If so, when?
Forecasts by their nature are very difficult to consistently get right and a better starting point is to understand the impact behavioural finance has on decision making processes.
Get the latest issue of FAnews