The Great Financial Crisis was Triggered by a Series of Unrelated Factors
Last updated:- Bad modelling and policies
- Conflicts of interest, Moral hazard
- Bad governance in Insurance Companies
- Overly complex derivatives and financial instruments
- Incorrect diversification
- Incorrect assumptions
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