The Great Financial Crisis was Triggered by a Series of Unrelated Factors

The Great Financial Crisis was Triggered by a Series of Unrelated Factors

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Table of Contents

Bad modelling and policies

  • Misunderstanding of model features (e.g. long-term vs short-term credit history)

    • E.g. customers who had just taken their first loan and made a single payment naturally had stellar short-term credit history, but it doesn't mean anything
  • Behaviour of models used by rating agencies could be learned and gamed by the banks by trial and error

  • Lumping together several individual loans into a single rate then using just the mean of the whole thing to describe the group

  • Assuming Gaussian distributions in Option pricing models.

    • E.g. Capital One stock depending on its solving its regulatory problems would either go higher (in case of a win) or it would go a lot deeper (in case of a loss). The distribution of outcomes in this Capital One case was bimodal, not at all Gaussian.

Conflicts of interest, Moral hazard

  • Fund managers with no skin in the game, took risks with other people's money without bearing any cost or risk

  • Rating agencies need to be honest but they may get more deals in the short-term if they are less careful and strict when giving out ratings

    • Because they know that many institutional clients are restricted to high-rate bonds only
  • Some managers only had short-term incentives

    • No penalty if their deals went bad long-term
  • Some managers got paid by volume, rather than by performance

Bad governance in Insurance Companies

  • Not knowing what exactly they were insuring

  • Confirmation bias

Overly complex derivatives and financial instruments

  • Very few people knew what was going on with the structured financial products so it was easier to hide risk

    • Because not many people were even reading the prospects

Incorrect diversification

  • Several apparently different bonds with the same underlying characteristics

    • Had very high correlation, providing no real diversification

Incorrect assumptions

  • Assumption/belief that real state prices just don't go down

Dialogue & Discussion