INTRODUCTION

This chapter explores the issue of systemic events in the context of some longstanding academic theories related to economic cycles and human behavior. By studying the characteristics of the numerous crises that have occurred throughout history, certain common themes emerge related to the economic climate that existed leading up to these events. For example, several theories exist around the impact of monetary policy on the development of asset bubbles. Some argue that so-called “easy credit” conditions have fueled investors' speculative buying of risky assets, which may have artificially inflated prices to unsustainable levels. That said, economic factors alone cannot be blamed for events such as the Great Depression or the Credit Crisis. The occurrence of these catastrophic financial events required the interplay between economic factors and the actions of individual consumers, investors, or corporations. Regarding the latter, this chapter discusses some theories related to human behavior and investment risk taking, speculative borrowing, and even the role that fear and the human brain may have played in contributing to financial crises.

After reading this chapter you will be able to:

• Describe the key components of Hyman Minsky's model of financial crises.
• Define and distinguish between homogeneous and heterogeneous beliefs.
• Describe the Rational Expectations Theory and how its key tenets were challenged following the Credit Crisis.
• Understand how theories such as Familiarity Bias and Risk Aversion may have played a role with respect to investor risk taking and decision making during periods of market stress.
• Explain the role that the human brain plays in risk taking and decision making.

MINSKY THREE-PART MODEL

Hyman Minsky was an economist and academic whose research tried to explain the economic drivers and characteristics of crises. Minsky's economic theories became a subject of focus following the Credit Crisis as many acknowledged that such theories could help at least partially explain its causes.

Minsky focused on credit market conditions and how access to credit can change over a business cycle. Minsky's belief was that surges in availability of credit in favorable time periods and reductions of such supply in weak economic periods cause volatility in financial activities and raise the possibility of a systemic crisis. Minsky's model was like that of other economists such as Fischer, Mill, Marshall, and Wicksell, who also focused on the instability in the supply of credit.

Minsky argued that a key mechanism that pushes an economy toward a crisis is the accumulation of debt by the non-government sector. He identified three types of borrowers who contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.

• The hedge borrower can make debt payments (covering interest and principal) from current cash flows from investments.
• For the speculative borrower, cash flow from investments can service the interest due on debt, but the borrower must regularly roll over, or re-borrow, the principal, which subjects them to partial refinancing risk.
• The Ponzi borrower (named for Charles Ponzi) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt, but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat.

The environment that existed during the Credit Crisis, in which millions of Americans borrowed frequently and excessively against the value of homes, best illustrates the Ponzi borrower theory. If the use of Ponzi finance is widespread enough in the financial system, then when the asset prices stop increasing, the speculative borrower can no longer refinance the principal even if able to cover interest payments. This scenario can cause the system to seize up: when the asset bubble eventually bursts, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments.

According to Minsky, outside shocks to the macroeconomic system are often the starting point for financial crises. These shocks will vary crisis to crisis, but all have similar characteristics that lead to a sort of euphoria on the part of investors. For example, leading up to the Great Depression in the United States there was quick growth of auto manufacturing and related expansion of the highways system, all at the same time the country began its rapid expansion of electricity use. Minsky argued if the shocks were large enough and wide in scope, the general populace expects increased profits from certain segments of the economy and may become overly aggressive in their risk taking. The corollary regarding the Credit Crisis was the tremendous runup in prices in the housing sector.

This euphoria leads to heightened and typically impractical views of the future economic climate and corporate profits. For example, in the late 1990s when the U.S. equity markets were booming because of the dot-com phenomenon, certain U.S. securities analysts called for a massive 15% annual growth in corporate profits over the next five-year period. This was clearly unrealistic, because if these analysts were correct, the GDP in the United States after that five-year period would be nearly 50% higher than at any point in history.¹ In response to these economic booms, banks begin to lend aggressively and new banks are created to fill the growing need for financing.

When inevitably the buyers become more conservative and sellers become more aggressive, this forms the beginning stages of the impending crisis. Banks and other forms of financing begin to quickly dry up as lenders fear credit losses on their loan portfolios. This instability of credit and early declines in asset prices led to recognition on the part of a large sector of the economy that it is time to increase their liquidity, and this fuels further selling by investors until eventually the asset bubble bursts.

DEBT DEFLATION CYCLE

A theory of economic cycles developed by Irving Fisher following the Great Depression holds that recessions and depressions are due to the overall level of debt shrinking (deflating). It holds that a decline in prices of assets and commodities leads to a reduction in the value of collateral and induces banks to call loans or refuse new ones; firms sell commodities and inventories because their prices are in decline, and the decline in prices causes more and more firms to fail. The debt–deflation cycle describes the fall in prices as firms/investors deleverage as they realize that they are overleveraged relative to a declining economy. Prices will continue to fall until leverage reaches normal levels.

BENIGN NEGLECT

The premise behind the Theory of Benign Neglect is that a financial crisis or panic will work itself out if allowed to follow its own course. One of the primary arguments that economists use to support this theory is the moral hazard scenario, whereby the very speculative behavior that might have fueled the crisis will only be further encouraged as investors observe a possibility that they will be bailed out by the government. There is also a longstanding argument that the more government authorities intervene regarding the current crisis, the more likely it is that individuals, having come to rely on public bailouts to limit or insulate their downside risk, will fuel an even greater asset bubble in the future. Note the following quote by Andrew Mellon in his advice to President Herbert Hoover:

When people get an inflationary brainstorm, the only way to get out of their blood is to let it collapse. It will purge the rottenness out of the system. High cost of living and high living will come down. People will work harder, live a moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.²

The opposing view often cited is that the risk of a panic that might ensue from the lack of government intervention would spread to the broader economy and wipe out investments of non-speculators as well. History tells us that panics are almost never left to their own devices. For example, during the crisis of the South Sea Company, the Bank of England promised to absorb payment of £400 of bonds issued by the company.³ Before the existence of the U.S. Federal Reserve System, a key tool used by the United States to address the risk of bank runs was the use of clearinghouse certificates, a currency replacement that represented the joint obligation of debt of a group of banks. In the early period of World War I in 1914, to stem panic selling, trading on the New York Stock Exchange (NYSE) was temporarily ceased in many global exchanges, including London. Similarly, following the bombing of the World Trade Center in 2001, the NYSE and other U.S stock exchanges were closed for a week.

A recent example of government intervention was the Credit Crisis in which the U.S. government intervened on a massive scale, providing over $600 billion of bailout funds to approximately 950 entities under its Treasury Asset Relief Program (TARP) and other similar programs.

A famous example of a contrarian view to the doctrine of benign neglect is that of Walter Bagehot, who felt that “loans should be granted to all comers” based upon sound collateral “as largely as the public asks for them,” and “however sudden the demand may be, it does not appear to us that there is any objection on principle to sudden issues of paper money to meet sudden and large extensions of demand.”⁴

BEHAVIORAL THEORIES

The impact of human behavior on the performance of financial markets and economic issues has been studied for a long time. Consider the following quote from a British economist:

Far be it for me to say that we ever shall have the means of measuring directly the feelings of the human heart. A unit of pleasure or of pain is difficult even to conceive; but it is the amount of these feelings which is continually prompting us to buying and selling, borrowing and lending, laboring and resting, producing and consuming; and it is from the quantitative effects of the feelings that we must estimate their comparative amounts.⁵

Among the many likely contributors to many crises throughout history, behavioral factors have been the subject of frequent industry and academic discussion. Some researchers argued that most of the causes of the crises are closely linked to behavioral factors⁶ while others found that subprime mortgage models suffered severe flaws in predicting consumer behavior given the significant underestimation of predicted default rates on more complex mortgages.⁷

Before discussing the role that human behavior may have played in the recent Credit Crisis, we must first discuss the Efficient Market Hypothesis (EMH) and the related Rational Expectations Theory, as behavioral finance challenges most of the assumptions associated with these theories.

EMH assumes, among other things, that market prices should fully reflect all available information about a particular asset or company up to that point in time. Another EMH assumption is that given the prior assumption, informed investors and traders identify any deviations between current prices and fundamental value and achieve quick arbitrage profits. Behavioral theory challenges these EMH assumptions, including the idea that EMH cannot adequately explain the frequent market anomalies that occur and that the influence of arbitrage on keeping markets efficient is limited.

The Rational Expectations Theory assumes that investors and markets are rational and that their beliefs change immediately in response to each market change. Investors who make optimal decisions under the assumption that they form their expectation about the future rationally has been an existing theory of macroeconomics for decades.⁸ Rational expectations do not require that an agent's predictions about the future always be correct. In fact, such predictions may turn out to be incorrect in every period, but still be rational. Instead, the primary test is whether, on average, over a long period time, expectations are correct. Agents are assumed to consider all relevant information and to make unbiased predictions based on this information. Some criticize the Rational Expectations Theory because it requires agents to possess too much knowledge. For example, to form rational expectations, agents must know the true structure and probability distribution of the economy.⁹ Given the inability of econometricians to estimate the economic model perfectly, it is unrealistic to expect agents to have such ability.¹⁰

History is full of all types of crises, panics, and manias, which on the surface would seem to contradict the assumption of rational behavior by market participants. Consider the following quote concerning the South Street Sea Bubble of 1720:

They had an immense capital dividend among an immense number of proprietors. It was naturally to be expected, therefore, that folly, negligence, and profusion should prevail in the whole management of their affairs. The knavery and extravagance of their stock-jobbing operations are sufficiently known (as are) the negligence, profusion and malversation of the servant of the company.¹¹

RISK AVERSION BIAS

In the seminal Sharpe-Lintner Capital Asset Pricing Model (CAPM),¹² which derives equilibrium prices for all risky assets, all agents are assumed to be risk-averse. All agents are expected to agree on the expected returns and on the variance/covariance matrix. Risk aversion is the tendency to feel the negative impact of a loss more acutely than the pleasure of an equal-sized gain.¹³ This phenomenon is captured by the Prospect Theory.¹⁴ Under this theory, decision makers' reaction to changes in wealth are modeled and are approximately twice as sensitive to perceived losses than gains. Under the tenets of the Prospect Theory, investors underweight outcomes that are deemed likely versus those that are viewed with near certainty. For example, during the Great Depression era Moody's ratings on stocks were considered the gold standard in terms of assessing the quality of securities. As such, many investors relied entirely on such ratings for decisions without doing the necessary due diligence.¹⁵ The massive drying up of liquidity in the credit markets during the Credit Crisis, particularly in structured products, led to fire-sale prices, availability of high interest rates, and unique profit opportunities for sophisticated investors. The fact that few such investors took advantage of these once-in-a-generation price anomalies and arbitrage opportunities is evidence of loss aversion bias, as EMH and related theories of rational investing would suggest that investors would have recognized that some of these price dislocations were temporary or even unjustified in some cases and would have jumped in to buy, thereby adjusting prices to more realistic levels.

ASSET PRICES

A fundamental idea behind the Rational Expectations Theory is that each trader is able to make inferences from market price about the profitability of his or her trade. Assuming a stock market with homogeneous information, all traders have at each period the same information, and the asset price conveys no extra information.¹⁶ This scenario is often referred to as the Martingale Property.

If this property held true, one would not expect to see significant volatility in observed historical asset returns, in particular, equity returns. However, agents may be boundedly rational about their beliefs about future payoff on risky assets and may have homogeneous views about future cash flows. But agents often disagree about the speed the asset price will mean-revert back to its fundamental value and expect that a mispricing will adjust at different time horizons.¹⁷

Many models have been proposed that incorporate the assumption that heterogeneity of expectations may play a significant role in asset pricing.¹⁸ Some studies have also suggested the combination of differences in beliefs and short sale constraints can explain persistent deviations of stock prices from intrinsic values.

Asset prices are known to experience significant increases in correlation during periods of market stress. A potential explanation for this phenomenon is the fact that traders come to the realization that the market price that they felt contained all pertinent information about a company, actually may not. As a result, they quickly adjust their behavior, exhibiting traits such as herding and homogeneous beliefs, which help to fuel increased asset correlations.

HOMOGENEOUS EXPECTATIONS VERSUS HETEROGENEITY

Heterogeneous beliefs represent a scenario whereby investors do not agree on the basic value of an asset. For example, an investor may be agreeable to overpay for a security today with respect to their analysis of its true worth, on the belief the security can be resold for a profit to another optimistic investor in the future. This behavior is blamed for helping to fuel prior asset bubbles.

In a dynamic environment with time-varying heterogeneous beliefs and short sale constraints, an asset buyer may be willing to pay more than his own expectation of the asset's fundamentals because he believes he can resell to an even more optimistic buyer for a speculative profit. This motive leads the asset owner to value the asset at a price higher than his already optimistic belief and therefore helps to fuel bubble.¹⁹

A key assumption in the seminal Modern Portfolio Theory is that all investors will have the same expectations and make the same choices given a set of circumstances.²⁰ The assumption of homogeneous expectations states that all investors will have the same expectations regarding inputs used to develop efficient portfolios, including asset returns, variances, and covariances. For example, if shown several investment plans with different returns at a particular risk level, all investors will choose the plan that boasts the highest return. Similarly, if investors are shown plans that have different risks but the same returns, all investors will choose the plan that has the lowest risk.

Agents are boundedly rational in that they choose from a variety of methods with which to form expectations, with homogeneous expectations representing just one choice.²¹ One of many reasons why an agent might shift from homogeneous to heterogeneous expectations is that agents analyze the past performance of their chosen predictor(s) and, if such choices performed poorly, in the future they might exhibit behavior that is less homogeneous with other agents. Agents can be heterogeneous in several ways:²²

• Preference (risk aversion)
• Agent-specific noise: Agent is an expected utility maximizer but may deviate from the optimal investment strategy due to random noise.
• Expectation: Even if all investors have the same preferences, they may have heterogeneous expectations regarding the future distribution of the random variable (returns in the stock market). For example, all agents estimate future distribution of returns looking at historical rates of return, but they are heterogeneous regarding their memory spans; some use the last 5 years' returns while others may analyze the past 10 years' returns.
• Strategy: Agents may have different investment strategies. Some may adjust their expectations and their investment policies frequently while others may take a longer-term approach.

Ahead are some examples of behavioral theories that have each played a role in explaining bubbles and crashes.

KEY POINTS

• Minsky identified three types of borrowers who contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers. The hedge borrower can make debt payments (covering interest and principal) from current cash flows from investments. For the speculative borrower, the cash flow from investments can service the debt, that is, cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The Ponzi borrower (named for Charles Ponzi) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat.
• The premise behind the Theory of Benign Neglect is that a financial crisis or panic will work itself out if allowed to follow its own course. Efficient Market Hypothesis assumes that market prices should fully reflect all available information about a particular asset or company up to that point in time. The Rational Expectations Theory assumes that investors and markets are rational and that their beliefs change immediately in response to each market change.
• Theories such as Efficient Market Hypothesis and Rational Expectations have been the subject of substantial challenge since history is full of all types of market anomalies that occur, including numerous crises, panics, and manias, which on the surface would seem to contradict the assumption of efficient markets and rational behavior by market participants.
• Under the Prospect Theory, decision makers' reaction to changes in wealth are modeled and are approximately twice as sensitive to perceived losses than gains and investors' underweight outcomes that are deemed likely versus those that are viewed with near certainty.
• Heterogeneous beliefs represent a scenario whereby investors do not agree on the basic value or expected return of an asset. For example, an investor may be agreeable to overpay for a security today relative to their view of its fundamental value, on the belief the security can be resold for a profit to another optimistic investor in the future, earning a speculative profit.
• Fight or flight represents innate response that involves significant changes in blood pressure and a rush of adrenaline to protect humans against physical threats. A detailed chemical study of the brain found that only one of its four regions, the amygdala, was the final place where the path of fear ended and determined that fear had several important implications for financial crisis. For example, extreme fear or panic may cause investors to liquidate more risky securities faster than they ordinarily would, even at losses, in exchange for safer investments.
• Familiarity bias played a significant negative role in the Credit Crisis as homeowners became accustomed to rising home values and failed to prudently account for the possibility that home prices might fall.
• A detailed chemical study of the brain found that fear had several important implications for financial crises. Perhaps the most significant of these is that the neuropathway for fear response circumvents the brain's higher capabilities, including those associated with rationality.