Recession Psychology — A Summary

March 18, 2014 § Leave a comment

The following is a brief write-up summarizing Nicholas Barberis’ paper entitled, ‘Psychology and the Financial Crisis of 2007-2008’. I wrote the summary for an assignment through Coursera’s Yale Financial Markets course taught by Robert Shiller. I decided to post it here because I believe Barberis’ ideas explain a lot of what caused the financial crisis. If you don’t mind reading 16 pages as opposed to my 2, I encourage you to read his full paper instead.

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Nicholas Barberis’ paper presents a cursory but insightful analysis of psychological factors behind the “great recession.”  Commentators often describe the crisis as being caused by a housing bubble; while this description may seem tightly accurate, such a shallow synopsis is hardly helpful. Barberis uses behavioral finance to understand the irrational mindset of market participants and suggests some answers for a future, healthier economy.

Home prices continued to increase aggressively through 2006. Home buyers and mortgage lenders were confident that real estate prices would continue to soar. This, and the subsequent crash, is reflected well in the graph below:

price to income(click to zoom)

Barberis asserts that both borrowers and lenders held irrational beliefs regarding real estate because of two factors. Firstly, borrowers and lenders over-extrapolated past performance of real estate and projected this trend disproportionately in the future. In psychological terms, these market participants used the representativeness heuristic—a judgment shortcut—to anticipate future performance of real estate.

The second factor causing irrationality is described as belief manipulation. Barberis believes, and I do too, that market participants generally wish to feel as if their work adds value to society. Thus, though lenders were incentivized by loan volume and not quality, it does not seem reasonable that they were simply greedy and uncaring of how their company and the economy could be impacted by such risky assets. Instead, lenders must have blinded themselves to the increasingly toxic loans they were booking for their organization. Barberis asserts that, to avoid the cognitive dissonance that would result from such unethical risk-taking, lenders chose to believe their actions were sound business practices.

Furthering the overconfidence and riskiness was the growing trend of securitizing (packaging and reselling) mortgages. These securities were inappropriately rated ‘AAA’ by credit rating agencies, effecting an international confidence and participation in the U.S. housing market. Barberis describes the rating agencies’ mistakes in the same terms as that of lenders and borrowers: over-extrapolation and belief manipulation. He adds that the complexity of these securities made it easier to blind oneself to risks and manipulate beliefs into overconfidence.

Banks, besides originating these risky loans, often took on substantial holdings of the securities. This ended up greatly exacerbating the damage to the economy. As banks’ saw some value decline in these securities, they were inclined to sell them, which caused the price to lower further, causing a downward spiral. Barberis describes two psychological factors, loss and ambiguity aversion, as encouraging this downturn. In brief, as losses were experienced and the market outlook was uncertain, investors experienced loss and ambiguity aversion, and consequently sold their securities, furthering asset deterioration. And, with the leveraged nature of the banking business, many banks were not capitalized sufficiently to absorb losses brought by this downturn.

In conclusion, Barberis makes a plea for behavioral finance: he believes a greater understanding of market participants’ irrationality can lead to financial innovations that bring about more efficient markets. I think that addressing regulators’ role in the recession, and their susceptibility to the same irrationality, would have been quite relevant in this discussion. It would also be interesting to see an analysis of how government interaction with the market, namely the encouraging of sub-prime lending (e.g. via FHA) and quantitative easing practices, may have caused additional confidence and inflated growth in the economy. Regardless, Barberis’ arguments are more than compelling and hold great explanatory power.

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