Behavioral Finance Economics 437

2007-2008 Financial Crisis As a behavioral finance economist might view it What happened? What caused it? What came after?

The Housing Bubble 2003 on: led by GSE’s financing Fannie Mae and Freddie Mac Basically, these two bought private mortgages Hearings in 2003, sought to regulate their activities Opposition to regulation led by Barney Frank and Chris Dodd – later to author the punitive Dodd-Frank law on private commercial banks

What are the GSEs Fannie Mae (1938) and Freddie Mac (1970) Created by Congress to buy mortgages By 2007, they owned more than half of all the private mortgages in the US In 2003, dramatically lowered the credit standards of mortgages that they were willing to purchase From 2003-2006, the mortgage market changed in the direction of “sub-prime” and “alt-a” mortgages

A few representative quotations From Barney Frank in 2003: “The more people exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstood some of the disaster scenarios “I do think I do not want the same kind of focus on safety and soundness that we have in the OCC. I want to roll the dice a little bit more in this situation” “I believe there has been more alarm raised about potential unsafety and unsoundness than, if fact, exists”

From Chris Dodd on July 13, 2008 ‘US Sen. Christopher Dodd moved this weekend to calm fears about the stability of the American financial system as the Bush administration unveiled an unprecedented rescue plan for the nation’s two largest mortgage finance companies. Dodd also warned that to suggest Fannie Mae and Freddie Mac were “in major trouble” is not accurate” ‘

2007 In mid-2006 home prices began to level off and start to decline in most large cities in the US By the summer of 2007, large parts of the US debt market ceased to function

The 2007 collapse of the Debt Market

Flight to Quality in 2007

Response of the Stock Market

Where was the smart money? July, 2007, National Institute’s Economic Review (which was the concensus) “The US Economy will grow by only 2.1 percent this year, recovering to 2.6 percent in 2008. Ben Bernanke, Fed Chmn, “given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” For the year, stocks were up 6.4 percent in 2007

2008 In March Bear Stearns fails In September, the government takes over FNM and FMC Stock market still above 12,000 Monday, Sept 15th Lehman fails Fed bails out AIG

By October 1 Dow at 10,830 on 29th of Sept Paulson proposes TARP Vote fails in the House of Representatives Succeeds, Dow finishes the week at 10,325 By March, 2009, Dow hits low 6,000s

So what happened to GDP

Post Crisis Conclusions Banks were the culprit (borrowers were innocent victims) FNM and FMC were bailed out – virtually no change in oversight Tax law preferences for housing left in place Dodd Frank Outlawed proprietary trading (which effectively outlawed market-making) Very restrictive lending rules (massive paperwork) Result: slowest economic recovery in history

Second Mid-Term Examination Thursday, April 14 Reading: Kahneman, Thaler books Articles: Fama-French DeBondt-Thaler Burton-Shah Chapter 14, pp. 147-153

The End