Post by Myla on Jan 22, 2008 13:11:41 GMT -5
Herd and Irrational behavior cause sub prime crisis
Regrettably what could be said of the cause of the sub prime mortgage crisis is the human irrational element; herd behavior. This "follow the crowd" behavior is ever inherent and never realized or made to realized to the policy makers that in every boom and bust, there lies the potential bubble burst.
Herd behavior, according to some academic literature, refers to uninformative information cascade. Under the environment or a specific situation, human, usually the investors, will follow the action taken by his predecessors, those who have made decision earlier. This can take the form of spread of word of mouth by peers, relatives, or some may refer to statistics revealed in the course of development. Normally if the returns result from the action taken is higher, without accessing the sustainability of the uptrend, it will converge the opinions that it is a bull market.
However, the cascade will not develop without any friction; if the statistics show that the crowd is small, it is hard for the cascade to develop smoothly. As most of us tend to jump into a bandwagon if the crowd is huge and the words are convincing. But if the crowd is huge and the statistics prove positive, the critical mass level will be broken and chain reaction will occur, which results in more people joining the crowd. Most usually this statistic provides a benchmark for most of the individual investors in decision making. Moreover, it cannot be wrong by following the crowd. Thus, the word "uninformative information cascade" is used to describe the herd behavior.
Let us now apply this to the current sub prime crisis to see how the cascade develops generally. First since Clinton administration, thanks to tech boom and fiscal discipline , the economy enjoyed surplus until the next President. Large surplus, economic growth, increasing positive expectations, all enabled the next administration to implement loose monetary policy, tax cut amounted to USD1.3 trillion. In fact, the amount was promised to the US public during Bush's presidential campaign. And the positive outlook, economic growth and forecast surplus shared by many statisticians and economists at that time further fuelled the positive view of the economic potential.
In fact, this is not the cause of the herd, the positive outlook shared was doomed by sudden drop in revenue gain. The post doc com bubble had arrived, and had erased the source of tax revenue from capital gain, and also the stock option. How much the gain generated by the tech boom, all was claimed by the bubble. This marked the first incident of the loss of confidence among the public on local economy. Industrial production was down 5% in 2001, however, the GDP was held steady by the domestic growth.
Before the economy could recover, it was hit again by series of event which further dragged down the sentiment and prompted interest cut by FOMC. 9/11 attack, anthrax, the talks of series of attack by Bin Laden, and followed by Afgan war, Saddam Hussein, and on the economic and business side, the revelation of accounting malpractices in Enron and the WorldCom, and international front was SARS which disturbed much of the business and travel, all had caused concern to the administration of the potential economic slowdown. The uncertainties prompted interest cut to buoy demand and bring economy out of the disinflation and deflation traps in 2003. The fed funds rate was reduced to 1.25%, rate of ten year treasuries bills were dropped from 7% to 3.5%. It was clear at that time that the concern of inflation was not in the picture.
The herd appears
Residential real estates, fueled by the low mortgage rate, began their surge in value. Amid economic uncertainty, property ownership was seen as safe heaven to the general public to insulate from depreciation of purchasing power and to safeguard the wealth status. Low mortgage rate and the encouragement by Government in the approval of mortgage loans engined the property boom; many members of the minority became first time owner of a house, and the ownership was made accessible to any applicant. Of the loans taken in 2006, fifth of the loans belonged to sub prime and another fifth to Alt_A mortgage, refers to people with good credit histories but whose monthly installment were for interest only.
The demand surge increased the price of the estate; seeing the value of the house of his neighbor increases boosted the morale and make the people flush. The surge started to attract speculators and investors to join the crowd. The "flippers" or the speculators started to buy and hoard more than one property in the hope that the price will increase and sell at the high to reap a profit through capital gains, some of the property was not even built yet. The cascade began to build up its steam and many were convinced of the upward potential of the property price. Encouraged by the low interest rate, or adjustable rate mortgage, many had taken up loans in order to jump into the bandwagon to become part of the herd.
The upward potential also caused other related booms. Flushed with increasing value of the property, other spending also increased; house modernization, expansion, demand of cars and other goods all generated positive euphoria in the economy. In fact, the shallowness of the dot com bubble was the consequence of the property boom.
The demand and the fads were further enhanced in its intensity by the positive grading of top notch grading agencies. The securitization of the mortgage loan which was then sold to investors in wall street was buoyed by positive remarks and grading made by financial institutions such as investment bankers. Since the securities were guaranteed by the banks, in the event of defaults, they are considered secured and safe. This ensured ease in raising the necessary money to fuel the mortgage demand, which caused the surge again in property sales and turnovers.
This cycle went on until the price of the house was too high for the average buyers. Some of the buyers joined the crowd too late to enjoy the boom. And when the adjustable rate mortgage clause expired, many found difficult to repay their loans. The herd took its toll when the positive sentiment evaporated when defaults started to set in. Suddenly the turnover and sale dried up, and the price crashed, causing more reluctance to join.
Business consultant, lecturer in business and economics and a business man. Interest ranges from economics, business, marketing, and management.
Contact:
john
money_politics@yahoo.com
More Details about sub prime crisis, how sub prime crisis here.
Regrettably what could be said of the cause of the sub prime mortgage crisis is the human irrational element; herd behavior. This "follow the crowd" behavior is ever inherent and never realized or made to realized to the policy makers that in every boom and bust, there lies the potential bubble burst.
Herd behavior, according to some academic literature, refers to uninformative information cascade. Under the environment or a specific situation, human, usually the investors, will follow the action taken by his predecessors, those who have made decision earlier. This can take the form of spread of word of mouth by peers, relatives, or some may refer to statistics revealed in the course of development. Normally if the returns result from the action taken is higher, without accessing the sustainability of the uptrend, it will converge the opinions that it is a bull market.
However, the cascade will not develop without any friction; if the statistics show that the crowd is small, it is hard for the cascade to develop smoothly. As most of us tend to jump into a bandwagon if the crowd is huge and the words are convincing. But if the crowd is huge and the statistics prove positive, the critical mass level will be broken and chain reaction will occur, which results in more people joining the crowd. Most usually this statistic provides a benchmark for most of the individual investors in decision making. Moreover, it cannot be wrong by following the crowd. Thus, the word "uninformative information cascade" is used to describe the herd behavior.
Let us now apply this to the current sub prime crisis to see how the cascade develops generally. First since Clinton administration, thanks to tech boom and fiscal discipline , the economy enjoyed surplus until the next President. Large surplus, economic growth, increasing positive expectations, all enabled the next administration to implement loose monetary policy, tax cut amounted to USD1.3 trillion. In fact, the amount was promised to the US public during Bush's presidential campaign. And the positive outlook, economic growth and forecast surplus shared by many statisticians and economists at that time further fuelled the positive view of the economic potential.
In fact, this is not the cause of the herd, the positive outlook shared was doomed by sudden drop in revenue gain. The post doc com bubble had arrived, and had erased the source of tax revenue from capital gain, and also the stock option. How much the gain generated by the tech boom, all was claimed by the bubble. This marked the first incident of the loss of confidence among the public on local economy. Industrial production was down 5% in 2001, however, the GDP was held steady by the domestic growth.
Before the economy could recover, it was hit again by series of event which further dragged down the sentiment and prompted interest cut by FOMC. 9/11 attack, anthrax, the talks of series of attack by Bin Laden, and followed by Afgan war, Saddam Hussein, and on the economic and business side, the revelation of accounting malpractices in Enron and the WorldCom, and international front was SARS which disturbed much of the business and travel, all had caused concern to the administration of the potential economic slowdown. The uncertainties prompted interest cut to buoy demand and bring economy out of the disinflation and deflation traps in 2003. The fed funds rate was reduced to 1.25%, rate of ten year treasuries bills were dropped from 7% to 3.5%. It was clear at that time that the concern of inflation was not in the picture.
The herd appears
Residential real estates, fueled by the low mortgage rate, began their surge in value. Amid economic uncertainty, property ownership was seen as safe heaven to the general public to insulate from depreciation of purchasing power and to safeguard the wealth status. Low mortgage rate and the encouragement by Government in the approval of mortgage loans engined the property boom; many members of the minority became first time owner of a house, and the ownership was made accessible to any applicant. Of the loans taken in 2006, fifth of the loans belonged to sub prime and another fifth to Alt_A mortgage, refers to people with good credit histories but whose monthly installment were for interest only.
The demand surge increased the price of the estate; seeing the value of the house of his neighbor increases boosted the morale and make the people flush. The surge started to attract speculators and investors to join the crowd. The "flippers" or the speculators started to buy and hoard more than one property in the hope that the price will increase and sell at the high to reap a profit through capital gains, some of the property was not even built yet. The cascade began to build up its steam and many were convinced of the upward potential of the property price. Encouraged by the low interest rate, or adjustable rate mortgage, many had taken up loans in order to jump into the bandwagon to become part of the herd.
The upward potential also caused other related booms. Flushed with increasing value of the property, other spending also increased; house modernization, expansion, demand of cars and other goods all generated positive euphoria in the economy. In fact, the shallowness of the dot com bubble was the consequence of the property boom.
The demand and the fads were further enhanced in its intensity by the positive grading of top notch grading agencies. The securitization of the mortgage loan which was then sold to investors in wall street was buoyed by positive remarks and grading made by financial institutions such as investment bankers. Since the securities were guaranteed by the banks, in the event of defaults, they are considered secured and safe. This ensured ease in raising the necessary money to fuel the mortgage demand, which caused the surge again in property sales and turnovers.
This cycle went on until the price of the house was too high for the average buyers. Some of the buyers joined the crowd too late to enjoy the boom. And when the adjustable rate mortgage clause expired, many found difficult to repay their loans. The herd took its toll when the positive sentiment evaporated when defaults started to set in. Suddenly the turnover and sale dried up, and the price crashed, causing more reluctance to join.
Business consultant, lecturer in business and economics and a business man. Interest ranges from economics, business, marketing, and management.
Contact:
john
money_politics@yahoo.com
More Details about sub prime crisis, how sub prime crisis here.