8/12/2019 One of the Factors That Caused the Financial Crisis Was a Real Estate

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One of the factors that caused the financial crisis was a real estate bubble. By

2006, due to a friction of some kind, or to irrational thinking, real estate prices had

been pushed up to unsustainably high levels. The bubble burst, triggeringwidespread defaults on subprime loans, dragging down the value of banks

subprime-linked holding, and setting off a run on the banking system.

Of all models, the one that may be most useful for understanding the recent

behavior of the real estate market is the belief based model that argues that bubbles

occur because, perhaps due to the representativeness heuristic. People over-

extrapolate the past when making forecast about the future. Home buyers, when

forecasting the future growth in house prices over-extrapolated the past growth in

these prices. This led them to overpay for their new homes and to take out loanswith excessively high loan-to-value ratios. Providers of outside financing were also

over-extrapolating. A real estate bubble formed because of an oversupply of credit

to home buyers, principally in the form of subprime loans. The rating agencies also

played a role in extrapolating. The agencies may have given AAA ratings to

securities that did not truly deserve them because they extrapolated the past growth

in home prices too far in the future.

The second factor linked to the financial crisis is that banks built up large holdings

of subprime loans and of related securities. When house prices started falling, the

value of these holdings also fell, and banks were affected. This led to a reduction in

the supply of credit to the economy. Banks subprime-linked holdings carried some

very significant risks. In spite of this banks took the exposures for the following

reasons. The first is the bad incentives view, which posits that people on the

mortgage desks of banks were aware of the risks exposure but did not care,

because of their compensation schemes. The second reason is that people on the

mortgage desks were genuinely unaware of the risks embedded in their subprime

holdings. The third reason is due to bad luck. An alternative hypothesis is that ofcognitive dissonance. Under this hypothesis, traders on mortgage desks were

vaguely aware that their business model might entail serious risks. However by

manipulating their beliefs, they deluded themselves into thinking that their

business model was not risky, but rather worth pursuing.

8/12/2019 One of the Factors That Caused the Financial Crisis Was a Real Estate

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During the crisis period, many kinds of risky assets experienced dramatic price

declines price declines that were surprisingly large, given the relatively small

delinquencies among subprime loans. To explain these large price drops,

researches have focused on institutional amplification mechanisms. However,

psychological amplification mechanismsspecifically, mechanisms related to lossaversion and ambiguity aversion may also have played a role. The idea is that, after

suffering losses in their risky asset holdings, both institutional and individual

investors experienced increases in loss aversion and ambiguity aversion. This led

them to reduce their holdings of risky assets, thereby pushing the prices of these

assets down even further.