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: customers who had just taken their first loan and made a single payment mistakenly had stellar short-term credit history
  • Models used by rating agencies could be gamed by the banks via trial and error

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

  • Assuming Gaussian distributions in Option pricing models.

    • E.g. Capital One stock bimodal distribution: If Capital One solved its regulatory problems the stock would 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 are incentivized to get more lax so they can have more deals in the short-term.

    • This workds because agencies know that many institutional clients are restricted to buying high-rate bonds. Higher ratings == more deals.
  • Some managers only had short-term incentives

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

Bad governance in Insurance Companies

  • Not knowing what exactly they were insuring, lack of understading of the intricacies of real estate structured products.

  • Confirmation bias

Overly complex derivatives and financial instruments

  • Very few people understood structured financial products so it was easier to hide risk

    • Not many people were even reading the prospects

Incorrect diversification

  • Several apparently different bonds with the same underlying characteristics

    • Had very high correlation, so there was no real diversification

Incorrect assumptions

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