Psychological Biases and Errors that led to historic bubbles and crashes

Which are the most common errors in crash scenarios? Are these the drivers of bubble-crash cycles? Are government regulations more favorable?

US Housing Bubble — rooted in the Dot-com bust.

Between 1996–2000 Nasdaq index increased exponentially, several dot-com companies went public without business plans or earnings. By March of 2000 the same index lost 9% in 3 days, three months later the S&P 500 followed. Between March of 2000 and October of 2002, $5 trillion were wiped out of the market. The Federal reserve proceeded to cut rates to artificially grow the economy, rates reached historical lows and stayed low for a few more years.

With interest rates low and Congress requesting greater access to mortgage loans for ‘subprime’ borrowers in the late 1990s (Community Reinvestment Act) the housing bubble began. Lenders started to offer ‘teaser’ rates on most Adjustable Rate Mortgages (take the loan at 3% and five years later you’re on the hook for 8+%). They would also allow subprime borrowers to borrow 100% of the value of the property (bringing average Loan to Value ratios to all time highs).

All these factors have been studied for years following the recession. However, there is a psychological aspect behind it all that just recently sparked the interest of economists. ‘Home ownership is the way to build wealth.’ With low interest rates, low barriers, and eager buyers, house prices rose more than 10% across the country. House prices started to go down in 2006, but the common idea of ‘house prices never go down’ led people to believe it was just a short dip. This mistake, known by behavioral economists as the non-regressive prediction bias led lenders, bankers, investors, and borrowers to ignore default risk. The numbers were there, loud and clear, but they wanted to believe something so badly that failed to see how wrong it was. Like that toxic relationship everyone tells you should abandon but you swear its just a phase.

Ignoring high default risk in subprime mortgages caused the collapse of Wall Street. Investors were attracted by the ‘high-risk free’ yield of mortgage backed securities (lots of mortgages bundled and sold to investors). A decline in house prices resulted in the destroyal of the collateral of such loans and the impossibility of the buyers to refinance or sell the houses to pay the debt. Investors were highly leveraged, meaning they borrowed a lot of money to purchase the mortgage backed securities, they could no longer contain their losses. And with so, the Great Recession started.

Now, back to the psychological aspects often ignored by the general public. We already mentioned the non-regressive prediction that led consumers believe house prices will always go up. In addition, the large availability of loans and the low barriers added to the demand of real estate investment. Seeing everyone taking out loans, and purchasing several properties led others to do the same, this is the availability heuristic. Third but not last, investors and lenders looked for information that supported their actions and investments, being blinded by their own beliefs (belief perseverance and confirmation bias). They would basically frame the information to support their own ideals.

To conclude, we know which non-behavioral aspects propelled the crash: availability of credit, extensive use of derivatives and leverage, a new technology (internet), ‘contagion’ among different industries (industries unrelated to the bubble were also affected by the crash). But we just started to study which behavioral aspects contribute to an economic collapse. Will we be able to learn from our mistakes?