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Objective

Critical assessment of the extent to which market failure and behavioural bias can explicate current financial crisis, referring to substantiation from at least one current financial crisis.

The purpose of the current study at hand is to elucidate in detail the financial crisis of the year 2008 in the USA by utilizing market failure as well as behavioural bias to illustrate the said crisis. By comprehending the causes behind the financial crisis can help in prevention of occurrence of financial crisis in the upcoming period (Goh et al. 2015).  

The current study elucidates in detail about the financial crisis of the year 2007 and 2008 is also referred to as worldwide financial crisis. The financial crisis of the year 2008 can be regarded by many economists to have worst financial crisis since the period of Great Depression of the year 1930s. The study throws light on the risk taking behaviour, excessive leverage of different US banks, excessive bail outs of various financial institutions, effects of quantitative easing strategies in addition to different asset relief programme that augmented the financial crisis of 2008.

Subsequent to the Second World War, government of United States became interested in re-establishing the domestic economy as well as generating new housing grounds. Thus, America introduced a mechanism of lending, also referred to as mortgage. This mechanism refers to a legal contract between two different parties that transfers property ownership to a particular lender as a specific security for acquirement of loans (Armantier et al. 2015). In essence, a mortgage permits one to loan money from a particular bank otherwise other institutions in a bid to fund houses.  The financial sector of USA invented an entirely new market for trading these mortgages. For the purpose of obtaining profits, banks in USA sold these kind of mortgages also referred to as mortgage backed securities to diverse other banks as well as investors not only in America but also all around the world. Alongside a particular fee, the claim for repayment in addition to interests gets shifted to the buyer party (Nelson and Katzenstein 2014). As default rates were historically low owing to high standards of underwriting for different mortgage based securities there were increase in prices in the housing market, banks and financiers

 

Figure: Housing Prices History USA

(Source: Cerutti et al. 2017)

However, during the year 1990s and early period of 2000s, prices of houses in the USA appreciated progressively and mortgage market felt buoyancy (Kumhof et al. 2015). Subsequently, this directed towards escalated growth in particularly issue of different mortgage based securities.

Background of the global financial crisis of 2008

As rightly indicated by Leamer (2015), investment banks purchased mortgages from various issuers of mortgage particularly in the growth phase of house prices. In actual fact, there was comparatively lesser number of new mortgages to securitize. Thereafter, traders began explore repackaging the MBSs along with other forms of debt. Nevertheless, the latter category of repackaging is a specific form of financial instrument that is also referred to as CDOs (collaterised debt obligations). As suggested by Rey (2015), CDOs are essentially securities that comprise of diverse kinds of debt, namely MBSs as well as corporate bonds that gets repackaged into a specific product and marketed to financiers in the secondary market. As per suppositions, the notion of pooling together varied categories of debt can lessen overall risk. These kind of repackaged assets have the need to be comparatively safe, although in actual fact, most of repackaged debt comprised of mortgages of inferior quality. In essence, these mortgaged were specifically loans that were sanctioned to different borrowers with low rating of credit and poor history of credit (that is to say sub-prime mortgages) (Balakrishnan et al. 2016). Regardless of these identified issues, majority of the rating agencies, counting Standard & Poor’s, Fitch Rating as well as Moody’s Investor Service were providing top rating of AAA to MBSs as well as CDOs.

Market failure primarily takes place at the time when freely functioning markets fail to deliver an effectual else wise socially optimal allotment of scarce resources. As rightly indicated by Bech et al. (2014), four different states of affairs that can signify market failures include asymmetric information, public goods, situation of monopoly in addition to different external effects. However, the current segment under consideration takes account of influence of monopoly along with asymmetric information on particularly financial crisis of United States.

Monopoly 

Treeck (2014) says this kind of market failure is effectually collusion otherwise abuse of power ensuing from concentrated market.  At a time when there is small number of corporations in a specific market, they might perhaps select to operate together to enhance their joint powers and exploit consumers in the market. As suggested by Goh et al. (2015), market failure originating from insufficient competition is mainly owing to supremacy of monopolies in the market economy. An important nature as well as characteristic of monopoly is essentially the presence high barriers to enter a specific industry/segment. Fundamentally, subsistence of monopoly in specific markets of US also contributed to certain extent to the financial crisis of the year 2008. As mentioned above in the study, major credit rating agencies were endowing asset based securities with AAA rating. In essence, the big credit rating agencies operated in an oligopoly market for rating agencies and had an advantaged position given by the regulators of the financial market. Also they acquired immunity from different legal prosecution over their presented ratings. In the period of 2008 crisis, business of repackaging as well as selling debts comprising of sub-prime mortgages were operating effectually (Armantier et al. 2015). In addition to this, the big credit rating agencies also became financially enthused to issue high ratings to these sorts of assets since they generated earnings by means of such kinds of securities. In addition to this, banks also started channelizing more money to fund home buyers belonging to low income categories (with low credit rating). However, this led to a vicious cycle and led to the burst of the housing bubble. With the burst of the housing bubble and defaults of mortgage loans, huge losses were encountered and institutional financiers holding these kinds of assets suffered huge amounts of losses (Nelson and Katzenstein 2014).

Market Failure and Financial Crisis of the year 2008

As mentioned by Leamer (2015), the mortgage market in US consisted of both primary as well as secondary market. Essentially, loans derived from different financial institutions namely banks were part of the primary market. However, these financial institutions were capable of obtaining finances they loan particularly from secondary markets. In addition to this, there were two different government backed units that in fact monopolised the entire secondary mortgage market, (that is to say, The Federal Mortgage Association along with The Federal Home Loan Mortgage Corporation). With the support of the government of the United States, these two institutions started to acquire finances at lower rates in comparison to other financial institutions (Balakrishnan et al. 2016). In actual fact, this benefit of acquiring funds helped them to dominate the entire secondary market by buying huge amounts of mortgage backed securities comprising of mainly the sub-prime mortgage. Nonetheless, at the time when prices of housing dropped and purchasers defaulted, both the said institutions encountered huge amount of losses in particularly mortgage security (Bech et al. 2014). This directed the government to bail them out for preventing worsening of the crisis situation and cease bleeding of the housing market, financial system and the entire economy.  

Asymmetric Information

As suggested by Leamer (2015), this type of failure of the market persists at the time when a specific individual or else a party has supplementary information than other individuals or else party and utilizes that benefit for exploitation of the other party.  In essence, finance is a market in specifically information time and again on the probability that they will be able to repay loan than the lender.

With regard to financial crisis of 2008, the investment banks were marketing sub-prime mortgages based securities were aware of subsistence of inferior quality in the assets. Nevertheless, in a bid to boost profits, they were ahead to market the securities to financiers that did not have inside information regarding problematic assets (Cerutti et al. 2017). In essence, they bought the said assets endowed with high rating assurance by major credit rating agencies, thinking they were protected investments.

However, in this context it can be hereby stated that availability of more accurate information particularly financial markets could have assisted financiers to know more in detail about lethal nature of investment assets. They could have known in detail about sub-prime mortgages and would be less keen to invest in the same. In case if the banks were unable to market investment products, they would have lesser funds at their disposal (Nelson and Katzenstein 2014). Subsequently less credit would be available to different purchasers with low income as well as poor profiles of credit. Essentially, this could have prevented plummeting of sub-prime mortgages and housing bubble burst.

Monopoly

Market Efficiency

The economic downturn as well as disorder in particularly financial markets that is indicated as the global financial crisis (GFC) has spawned a striking expression of blame. Goh et al. (2015), suggests that the efficient market hypothesis (EMH) is the notion that financial markets ruthlessly make use of all obtainable information at the time of establishing prices of security. As per Goh et al. (2015), an efficient market is necessarily the one in which prices complete replicate all the available important information. At the micro-level , this notion of market efficiency can be considered to be the extent to which financial security prices replicate information that is necessarily relative to different other securities specifically within the same class of asset. Again, at the macro level, the concern is regarding whether the entire market on the whole replicates all available information. This is to say, whether share market is necessarily fairly priced in comparison to relatively less risky asset, for example, government debt.

In spite of several limitations of the theory of market efficiency, there is specific claim that it is accountable for the present global crisis. There is a belief in the fact that market efficiency was accountable for asset bubble, for different investment analysts miscalculated risks. There are many who believed in accountability of market efficiency for the collapse of the firm Lehman Bros (Kumhof et al. 2015). Scholars were of the view that efficient market might have forecasted the crash.

Moral Hazard

Goh et al. (2015) suggests that moral hazard subsists in a specific market in which a specific individual or corporation undertakes more risks that they ought to be. This is because they know that they are either covered by insurance or else they believe that the government shall shield them from any kind of damage occurring as an outcome of the risks.

As correctly mentioned by Treeck (2014), behavioural bias also known as human factor influences perception regarding information and process of arriving at decisions.  The current study at hand focuses on two pertinent facets namely the confirmation bias as well as confidence bearing in mind behavioural facets that influence the financial crisis of the year 2008. The current section hereby highlights the psychological pitfalls that led to the financial crisis

Confirmation Bias 

As rightly put forward by Armantier et al. (2015), confirmation bias directs people to essentially overweight specific information that actually confirms their beliefs and prior information. On the other hand, confirmation bias also underweight information that necessarily disconfirms and disregards their own views. Risk managers also were susceptible to this confirmation bias. Essentially at the time when business concerns started experiencing losses during the first quarters of the year 2007, the team responsible for management of risk failed to implement supplementary methodologies for averting the identified risks. Thereafter, matters got worse and led to financial crisis. Financiers purchased high rated securities mainly with the sub prime mortgages elements. Essentially, the sophisticated investors should have acquired more information regarding the structure of the securities along with the risk associated to the same (Nelson and Katzenstein 2014). Instead, the investors went into investments in these securities as these products were extremely profitable and therefore they depended on information that was in line and in conformation with their own beliefs and views. For instance, they depended on the information on high ratings (AAA) conferred by the rating agencies, various news stressing on the positive trends on housing prices and mortgage supported securities and many others (Leamer 2015). As such, they ignored all the available conflicting information that presented bubble forming in the prices of housing, and risk associated to the complicated nature of the securities and many others.

Overconfidence 

An important feature of the behavioural finance is that financiers are inclined to express excessive optimism that necessarily stems from overconfidence. A detrimental effect of the same is that it shows the way to excessive trading by financiers as substantiated by escalating popularity of ground-breaking mortgage securities observed in the milieu of lively housing market. Overconfidence was also exhibited by another set of people namely the home purchasers of the US (Cerutti et al. 2017). They in actual fact overrated their potential to acquire mortgage loans that in turn led to higher degrees of leverage along with abundance of sub prime mortgage that again banks utilized to package into complicated security assets. Altogether these factors directed the way towards financial crisis of the year 2008.

Heading Bias

As rightly put forward by Bech et al. (2014), focus of expansion (abbreviated as FOE) indicates the heading direction of a particular observer during the period of self motion. Prior experiments reflect that humans have the potential to appropriately perceive their own heading from a particular optic flow. Nevertheless, at the time when the setting basically contains an independently moving item, then the judgements on heading might perhaps get biased. Thus, it can be said that when a specific item approaches a particular observer, this heading bias might be owing to discrepant optic flow specifically within object contours that emanates from a secondary form of FOE. In itself, sub-prime mortgage currently indicate towards present bias. As per present bias, individuals have the tendency to concentrate on the present and move as per present conditions and tend to undervalue future period. During the pre-crisis period, individuals were heading in a direction with a focus on the present situation and arrived at decisions that they later regretted (Cerutti et al. 2017). This is because the factor “now” moved with time. Individuals might have put off an undesirable decision, planned to do something in the future period, however, when the future period arrived, they changed their mind and shelved their prior decision. This can be referred to as a heading bias as their judgement on sub prime mortgage changed. Investors headed towards taking up the mortgage with focus on present and ignored the threats that the risky assets might pose.

Conclusion

The financial crisis of the year 2008 emanated from housing bubble in the United States that in turn stretched and widened to the entire financial system as well as economy.  The above study helps in gaining comprehensive understanding regarding diverse features of market failure along with behavioural bias that led to financial crisis. Essentially, this insight into the financial crisis is expected to generate more awareness among different entities namely regulators, different financial institutions, financiers, as well as credit rating agencies among many others that in turn can avoid financial crises of similar nature in the future

References

Armantier, O., Ghysels, E., Sarkar, A. and Shrader, J., 2015. Discount window stigma during the 2007–2008 financial crisis. Journal of Financial Economics, 118(2), pp.317-335.

Balakrishnan, K., Watts, R. and Zuo, L., 2016. The effect of accounting conservatism on corporate investment during the global financial crisis. Journal of Business Finance & Accounting, 43(5-6), pp.513-542.

Bech, M.L., Gambacorta, L. and Kharroubi, E., 2014. Monetary policy in a downturn: are financial crises special?. International Finance, 17(1), pp.99-119.

Cerutti, E., Dagher, J. and Dell'Ariccia, G., 2017. Housing finance and real-estate booms: a cross-country perspective. Journal of Housing Economics, 38, pp.1-13.

Goh, B.W., Li, D., Ng, J. and Yong, K.O., 2015. Market pricing of banks’ fair value assets reported under SFAS 157 since the 2008 financial crisis. Journal of Accounting and Public Policy, 34(2), pp.129-145.

Kumhof, M., Rancière, R. and Winant, P., 2015. Inequality, leverage, and crises. American Economic Review, 105(3), pp.1217-45.

Leamer, E.E., 2015. Housing really is the business cycle: what survives the lessons of 2008–09?. Journal of Money, Credit and Banking, 47(S1), pp.43-50.

Nelson, S.C. and Katzenstein, P.J., 2014. Uncertainty, risk, and the financial crisis of 2008. International Organization, 68(2), pp.361-392.

Rey, H., 2015. Dilemma not trilemma: the global financial cycle and monetary policy independence (No. w21162). National Bureau of Economic Research.

Treeck, T., 2014. Did inequality cause the US financial crisis?. Journal of Economic Surveys, 28(3), pp.421-448

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