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

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