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Commonalities of Asset Pricing Bubbles Lauren Frances Pensegrau University of South Carolina - Columbia

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Commonalities of Asset Pricing Bubbles Lauren Frances Pensegrau University of South Carolina - Columbia University of South Carolina Scholar Commons Senior Theses Honors College Spring 5-5-2016 Commonalities of Asset Pricing Bubbles Lauren Frances Pensegrau University of South Carolina - Columbia Follow this and additional works at: https://scholarcommons.sc.edu/senior_theses Part of the Finance and Financial Management Commons Recommended Citation Pensegrau, Lauren Frances, "Commonalities of Asset Pricing Bubbles" (2016). Senior Theses. 63. https://scholarcommons.sc.edu/senior_theses/63 This Thesis is brought to you by the Honors College at Scholar Commons. It has been accepted for inclusion in Senior Theses by an authorized administrator of Scholar Commons. For more information, please contact [email protected]. COMMONALITIES OF ASSET PRICING BUBBLES By Lauren Pansegrau Submitted in Partial Fulfillment of the Requirements for Graduation with Honors from the South Carolina Honors College May, 2016 Approved: William Harrison Director of Thesis West Summers Second Reader Steve Lynn, Dean For South Carolina Honors College Pansegrau 2 Table of Contents 1. Thesis Summary ................................................................................................................ 4 2. Introduction ....................................................................................................................... 5 3. Defining “Bubble” ............................................................................................................. 6 4. The Subprime Mortgage Crisis .......................................................................................... 7 4.1 Catalyst: Federal Government Pushes Homeownership .............................................................. 8 4.1.1 Tax Incentives for Homebuyers ............................................................................................ 9 4.1.2 Federal Mandates to Fannie Mae and Freddie Mac ............................................................ 10 4.1.3 Community Reinvestment Act of 1977 .............................................................................. 11 4.2 Drivers .................................................................................................................................... 12 4.2.1 Consumers .......................................................................................................................... 12 4.2.2 Lenders ............................................................................................................................... 14 4.2.3 Government Sponsored Enterprises (GSEs) ....................................................................... 15 4.2.4 Investment Banks ................................................................................................................ 17 4.2.5 Regulators ........................................................................................................................... 19 4.2.6 Credit Rating Agencies ....................................................................................................... 21 5. The Crash of 1929 ........................................................................................................... 22 5.1 Similarities to the Subprime Mortgage Crisis ............................................................................ 22 5.2 Catalyst: Federal Government Promotes The Markets ........................................................... 23 5.2.1 Liberty Bonds ..................................................................................................................... 23 5.2.2 Postwar Monetary Policy .................................................................................................... 23 5.3 Drivers .................................................................................................................................... 24 5.3.1 Consumers .......................................................................................................................... 24 5.3.2 Lenders/Banks .................................................................................................................... 26 5.3.3 Regulators ........................................................................................................................... 27 5.3.4 Role of Bubble Psychology ................................................................................................ 28 5.4 Differences from the Subprime Mortgage Crisis ....................................................................... 29 6. The Dot-Com Bubble ...................................................................................................... 30 6.1 Catalyst: Policy Response to the Savings & Loan Crisis Sets the Stage ................................... 30 6.2 Drivers ........................................................................................................................................ 31 6.2.1 Federal Government ........................................................................................................... 32 6.2.2 Consumers .......................................................................................................................... 33 6.2.3 Venture Capitalists .............................................................................................................. 33 6.2.4 Investment Banks ................................................................................................................ 34 6.3 Impacts ....................................................................................................................................... 35 7. Conclusions ..................................................................................................................... 36 7.1 Common Catalysts ..................................................................................................................... 37 7.1.1 Monetary Policy .................................................................................................................. 37 7.1.2 Political Initiatives Divert Capital ...................................................................................... 37 7.2 Common Drivers ........................................................................................................................ 38 7.2.1 Perversion of Supply and Demand ..................................................................................... 38 7.2.2 Herd Behavior ..................................................................................................................... 38 7.2.3 Market Risk vs. Career Risk ............................................................................................... 39 7.2.4 The Greater Fool Theory .................................................................................................... 39 7.2.5 New Eras ............................................................................................................................. 39 7.3 Common Impacts ....................................................................................................................... 40 Pansegrau 3 7.4 Implications for Economic Theory ............................................................................................ 40 7.4.1 Random Walk Theory ......................................................................................................... 40 7.4.2 Rationality of Market Actors .............................................................................................. 41 7.4.3 Efficient Market Hypothesis ............................................................................................... 43 7.4.4 Capitalism as the Premier Method of Organizing Trade .................................................... 44 7.5 Possibility of Bubble-Spotting ................................................................................................... 45 8. Key Takeaways ................................................................................................................ 46 Works Cited ............................................................................................................................ 47 Pansegrau 4 1. Thesis Summary The focus of this thesis will be to examine the similarities between the 2007-2008 Subprime Mortgage Crisis and other crises resulting from the collapse of an asset pricing bubble throughout United States financial history. Particular emphasis will be placed on the real estate and stock bubbles of the 20th century, including the events leading up to the Great Depression and the Savings and Loan (S&L) crisis of the late 1980s. I explore commonalities throughout the life cycle of a bubble, from the catalysts that lead to bubble formation, to the drivers that fuel both expansion and collapse, and finally, the impacts that persist in the aftermath of a bubble bursting. It is my belief that rising asset prices that eventually form bubbles are not necessarily bad from the start, but that there may be a common catalyst, like a monetary policy, political initiative or other event, that creates excess liquidity and diverts capital into a particular market, leading price to stray from fundamental value. From there, a number of factors come into play to drive the expansion: social, emotional and psychological factors, like herd behavior, self-generating cycles, perverse incentive structures that encourage short-term thinking and disregard for long-term impacts, among others. Finally, I explore the impact of bubbles, post-collapse.
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