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Irrational Exuberance: an Evolutionary Perspective on the Underlying Causes of the Financial Crisis

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Irrational Exuberance: an Evolutionary Perspective on the Underlying Causes of the Financial Crisis A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Hira, Andy Article — Published Version Irrational exuberance: An evolutionary perspective on the underlying causes of the financial crisis Intereconomics Suggested Citation: Hira, Andy (2013) : Irrational exuberance: An evolutionary perspective on the underlying causes of the financial crisis, Intereconomics, ISSN 1613-964X, Springer, Heidelberg, Vol. 48, Iss. 2, pp. 116-123, http://dx.doi.org/10.1007/s10272-013-0452-0 This Version is available at: http://hdl.handle.net/10419/113691 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu DOI: 10.1007/s10272-013-0452-0 Financial Crisis Andy Hira* Irrational Exuberance: An Evolutionary Perspective on the Underlying Causes of the Financial Crisis In the years leading up to the crisis, there were a number of warning signs that signalled a breakdown of basic fi duciary soundness. The following article addresses the problem of inattention to those warning signs and calls into question the commonly proposed causes of the crisis. This paper suggests that the more intangible aspects of human nature revealed by the crisis are the key to unlocking the paradoxical self-destructive behaviour behind it and thus the types of remedies that need to be considered. The fallout from a fi nancial crisis can endure for years, often areas not directly related to housing. AIG, which would fi nd leading to prolonged collapses in asset prices, profound itself at the centre of the crisis, took on unfathomable levels declines in output and employment, and an explosion of of risk. Yet in August 2007, AIG Financial Products Group government debt.1 This paper examines the commonly pro- manager Joe Cassano said, “It is hard for us, without being posed causes of the crisis and fi nds them wanting, which fl ippant, to even see a scenario within any kind of realm of explains why normal economic policy tools have proven reason that would see us losing one dollar on any of these so ineffective up to this point. I suggest the more intangi- [insurance] transactions.”3 This statement was echoed by ble aspects of human nature revealed by the crisis are the many others and is the focus of this paper: how did so many key to unlocking the paradoxical self-destructive behaviour smart people miss the obvious, both to their own detriment behind it and thus the types of remedies that need to be as well as to that of others? considered. The FCIC report traces the roots of the collapse to what it Proximate causes calls a “shadow banking system” that developed primar- ily over the last three decades. In particular, it points not to The offi cial 2011 report of the US Financial Crisis Inquiry the repackaging of mortgages and their securitisation but Commission (FCIC) offers perhaps the most comprehen- to regulatory problems, such as principal-agent problems, sive event-based discussion of the fi nancial crisis.2 The moral hazards and a basic lack of regulatory capacity. On most prominent target of the FCIC report is the fi nancial a more fundamental level, it focuses on the breakdown of regulatory system, including the Federal Reserve, the Se- “private regulation”, such as the failure of rating agencies or curities and Exchange Commission (SEC) and related fi nan- the fi nancial institutions themselves to appropriately evalu- cial regulatory agencies. Thus, its focus is not necessarily ate their portfolios based on mortgage securities and de- the housing bubble per se but the way the bubble worked rivatives. Lewis identifi es as a key source of the crisis the its way through the fi nancial system, wreaking havoc in the movement of investment houses from private ownership to public companies, thus allowing them to take on huge risk 4 * This is a highly abbreviated version of the paper. For the full paper, without risking personal wealth. The same thing happened please contact the author. with the rating agencies; both Moody’s and Standard & Poor’s went public in 2000. After Moody’s went public, prof- 1 C.M. Reinhart, K.S. Rogoff: This Time is Different: Eight Centuries of Financial Folly, Princeton 2009, Princeton University Press, p. 224. its increased by 900 per cent; by 2002 it was worth more 2 Financial Crisis Inquiry Commission: The Financial Crisis Inquiry Re- than Bear Stearns. More complex fi nancial instruments, port: Final Report of the National Commission on the Causes of the such as mortgage securitisation and credit default options, Financial and Economic Crisis in the United States, Washington 2011, US GPO. were naturally more attractive to rating agencies, which 3 W.A. Sahlman: Management and the Financial Crisis (“We Have Met Andy Hira, Simon Fraser University, Burnaby, Can- the Enemy and He is Us…”), in: Economics, Management, and Finan- cial Markets, Vol. 5, No. 4, 2010, pp. 11-53, here p. 27. ada. 4 M. Lewis: The Big Short: Inside the Doomsday Machine, New York 2010, Allen Lane, pp. 257-258. Intereconomics 2013 | 2 116 Financial Crisis could charge higher fees for assessing them. Rating agen- three to four times the fees for them that they did for prime cies were often only given one day to evaluate credit data mortgages.8 These led to outright fraud in a number of well- from an investment bank. Nonetheless, from 2002 to 2007 documented cases. For example, in 2002 Household Fi- they earned $3.2 trillion in subprime-based mortgages as- nance Corporation paid a $484 million fi ne to 12 states for sessment.5 The idea of creating transparency in ratings deceptive loans in which borrowers were led to believe they methodologies has been regularly dismissed, as it is con- were going to be paying substantially lower interest rates. sidered proprietary knowledge. Beyond this, a number of accounts suggest that lenders The FCIC report claims there were a number of warning were shocked that homeowners would even consider de- signs that accumulated in the years up to the crisis that faulting on loans, despite the fact that their mortgages far signalled a breakdown of basic fi duciary soundness. For exceeded the value of their houses after the crash. There example, leverage ratios, i.e. the amount of committed were several well-publicised cases of wealthy individu- capital to assets, increased precipitously over the period, als, quite capable of paying off the mortgages they took including in commercial and real estate lending. Another out, simply walking away from their houses when prices obvious sign was the increasingly unsustainable rise in crashed.9 No doubt this occurred countless times with housing prices. Nonetheless, in Congressional testimony those who purchased housing for speculative purposes, in March 2007, Chairman of the Federal Reserve Ben Ber- i.e. to “fl ip it”. It appears that homeowners naively regarded nanke said, “The impact on the broader economy and the housing as a stable and predictable investment, thus over- fi nancial markets of the problems in the subprime markets leveraging their own capital in one place. Overreliance on seems likely to be contained.”6 The struggle to explain such housing reduces savings investment vehicles and creates widespread blindness to the warning signs is perhaps the a construction boom which, in turn, feeds the feeling, how- most interesting question to explore. ever irrational, that prices cannot decline. The construction boom, meanwhile, feeds a secondary boom in fi nancial Deeper causes of the crisis markets and equities.10 Since mortgages were securi- tised, borrowers’ lack of collateral became less important Housing as an end to lenders. Ultimately, the purchasers of those securities would be the ones left holding the bag. These perverse in- Home ownership has always been part of the American centives led to the development of high-risk products, such dream, a symbol of middle-class attainment suggesting as the proliferation of adjustable-rate mortgages, mortgag- that a lifetime of work led to a visible reward. US policy to es with balloon payments, mortgages for which the buyer support home ownership for everyone, beginning with the could set their own payments, and even “negative equity” hallowed mortgage tax credit, was overly aggressive, creat- mortgages in which the principal was never paid off. There ing unusually high-risk mortgages. Policies dating from the were even loans referred to as “no documentation” and “no Clinton years and continued throughout the Bush admin- income, no job” loans.11 istration pushed the government-sponsored enterprises (GSEs, namely Fannie Mae and Freddie Mac) to extend Monetary policy loans to riskier borrowers, but evidently the housing bubble was present across large parts of Europe as well. The un- Continuing ongoing global imbalances in savings and derlying assumption which fuelled this bubble is that hous- consumption, leading to both trade and fi scal defi cits, are ing provides collateral that is stable, despite the obvious untenable.
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