Behavioral Finance

Market Bubbles & Crashes

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 Introduction

In this section, we take you on a historic tour of some of the great bubbles and
crashes throughout history, from the famous tulip mania of the 17th century to the
recent housing bubble and credit crisis.

Our goal in this section is to document, and try to categorize, the biases and errors
that lead to these bubbles. We would like to develop an understanding of which
errors are common to all crash scenarios, versus those that crop up only from time
to time, and do not seem to be essential drivers of the bubble to crash cycle.

We would also like to identify some non-behavioral factors that characterize most
bubbles: is a certain type of economic environment essential to permit a bubble to
start? Is it necessary that all investors “buy in” to the bubble? Are certain
regulatory environments more favorable than others?

We will begin with an in-depth analysis of the recent housing bubble and credit
crisis. The history of other crises will be brought to you via a series of website
articles. You will read about the history of each bubble, and then identify which of
a list of factors appear to be prevalent in each case.

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 US Housing Bubble:
Roots in Dot-Com Bust
• Between 1996 – 2000, the technology-heavy Nasdaq equity index increased more
than 8-fold, from 600 – 5,000
• Thousands of “dot-com” companies went public despite no business plan and no
earnings

• The dot-com boom finally ended in early 2000

• The Nasdaq index peaked in early March, and lost 9% in 3 days that same month
• The S&P 500 and the broader US stock market turned south 3 months later

• $5 trillion in market value of technology companies wiped out between March 2000
and October 2002

• The Federal Reserve embarked on a sustained series of rate cuts to inject growth into
the economy
• Interest rates fell from 6.00% to 1.75% during 2001, and remained at historically
low levels for several years

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 US Housing Bubble:
A “perfect storm” fueled subprime borrowing
• Interest rates fell from 8% to historical low of 5.5% on 30-year fixed rate mortgages
from 2000–2003, following rate cuts from the Fed in response to the dot-com bust
• Meanwhile, Congress in the late 1990s had passed a bill mandating greater access to
mortgage loans for “subprime” borrowers, whose credit history would previously have
shut them out of the mortgage market
• Lenders also offered low “teaser rates” (as low as 3%) on most mortgages for the first
few years, further reducing the required monthly payments and enabling an even
larger group of subprime borrowers to take out loans
• Borrowers’ incomes were expected to increase during the teaser period, after
which the higher payments were expected to be within the borrowers’ budgets
• 5 year teaser periods were standard practice for “prime” (high credit) borrowers
• Subprime teasers, however, were often only 2 – 3 years, reducing the time window
for these borrowers’ incomes to catch up to post-teaser hikes in monthly payments
• In a final abandonment of cautious lending practices, subprime borrowers were
permitted to borrow 100% of the value of their property, since many had no savings
with which to make a down payment
• Previous practice among mortgage lenders was an 80% “Loan to Value” (LTV) ratio,
with borrowers using their savings for the remaining 20% of the purchase price
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 US Housing Bubble:
The “American Dream” of Home Ownership
• In the early 2000s, US consumers were sold on concept that home ownership is the
best way to build wealth
• President Bush’s 2004 campaign slogan was “The Ownership Society”
• House Prices soared as borrowers of all credit levels rushed to take advantage of the
low mortgage rates, even lower teaser rates, subprime-friendly mortgage lenders, and
the option to borrow 100% of the property price
• Annual house price appreciation was greater than 10% in California, Florida & most
north-eastern states in 2002.
• Multiple states recorded price increases of 25% per year from 2003 – 2005
• The surge in home prices boosted financial wealth of home owners from 2002 –
2007; household net worth increased by $18 trillion during this period
• At the peak, California had a record half-million real estate licensees; one for every
52 adults living in the state
• The house price bubble reached its peak at the end of 2005
• Even as house prices began to turn south in 2006, the mantra among both homeowners
and the lending community was that “house prices never go down”
• This non-regressive prediction bias led borrowers, lenders, investment bankers, and
the international investing community to ignore subprime default risk… 5
 US Housing Bubble:
Increased Borrower Default Risk Largely Ignored
• Lenders and investors were complacent about higher default risk on subprime loans:
• Mortgage lenders offloaded the risk by packaging the loans into “mortgage-backed
securities” and sold them to Wall Street
• Wall Street offloaded the risk by selling slices of these loans to global institutional
investors, who had increasing appetite for their relatively higher “yield” (i.e.,
expected rate of return) in the prevailing low interest rate environment
• Global investors weren’t worried about defaults, since the loans were backed by the
real estate collateral: borrowers who could not pay would have their houses re-
possessed and sold to pay off the loan – and they believed that house prices never
go down

• Subprime borrowers were also complacent about defaulting on their mortgages after
the “teaser rate” expired and monthly payments ballooned; they had options:
• Restructure their loan into a new mortgage with another low teaser rate
• Sell the property to pay off the loan
• Both of these alternatives were facilitated by continued low interest rates and rising
house prices between 2002 – 2006.
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 US Housing Bubble
The Bubble Timeline
US Housing boom begins to gain
momentum – house prices
rising 10% or more in some states

Significant US Home ownership rates peak at 69%:

increases in 11% increase from long run stable
subprime lending 62% ownership rate
Community
Reinvestment Act AZ, CA, FL, HI, NV
encourages sub- house price
prime lending increases reach 25%

US Home construction
Dot-com bubble index falls 40%
bursts – Fed begins in 12 months
a series of 13
straight interest rate Boom in U.S housing
cuts over 18 months. market ends

Plunge in existing home sales

steepest since 1989

1999 2000 2001 2002 2003 2004 2005 2006 2007 7

 US Housing Bubble
The Crash Timeline

New Century (mortgage

U.S Consumer Confidence
originator) files Countrywide Home prices fall for
at 16 year low, and
for Chapter 11 bank run 10th straight month
fifth lowest level ever.
bankruptcy protection
2007 sees largest drop
Two Bear Stearns President Bush announces 406 people arrested
in existing home sales
Hedge Funds collapse New Hope Alliance: for mortgage fraud
for 25 years
limited bailout of
subprime homeowners

Apr 2007 Jul 2007 Oct 2007 Jan 2008 Apr 2008 Jul 2008 8
 The Collapse of the Subprime Market

$1.3 Trillion The value of subprime

24%
mortgages in U.S by March 2007

The number of Subprime lenders 25 The annual plunge in

who declared bankruptcy in 2007 Home Construction in 2007

The percentage of prime loans that Spring 2008

< 5%
were 90-days delinquent or in foreclosure, in…

5%

The percentage of subprime loans that Fall 2007

were 90-days delinquent or in foreclosure, in… 16%

22%
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 US Housing Crash & Credit Crisis

• Ultimately the party ended, as the fevered property market turned south across the
entire US in 2006
• As subprime teaser periods ended and borrowers could not make the higher
payments, they were forced to sell their homes
• Falling property values on loans that were for 100% of the purchase price meant
that lenders did not recoup the full value of the loan
• The increasing size and quantity of shortfalls rippled through the international
investment community, as investments in pools of mortgage loans failed to deliver
the expected cash flows

• High levels of investor leverage (borrowing) significantly amplified investors’ losses,

leading to the Great Recession in the US, and a global economic slowdown of previously
unmatched proportions

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 US Housing Crash & Credit Crisis
Behavioral biases

• Behavioral biases that fuelled the housing bubble and subsequent crash:

• Availability heuristic: the increasing number of borrowers, and the growing

availability of loans, led to “cascades”, in which house “flipping” became a national
pastime and added to demand for real estate investments

• Non-regressive prediction: no one had seen a nationwide fall in US house prices, so

buyers and investors alike assumed that this could not happen, fueling…

• Belief perseverance and confirmation bias, as greater numbers of global

participants in the US housing market looked only for information that supported
their view of ever-increasing house prices and thus the safety of their related
investments

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 Non-Behavioral factors seen in Bubble-Crash Cycles
• Since the so-called Tulipomania of the 1630s, the world has seen a multitude of bubble-
crash cycles
• There are many non-behavioral factors that tend to facilitate asset bubbles, although
not all of them are present in every bubble-crash cycle
• Availability of credit: easy borrowing conditions are precursors to many financial
bubbles, as the addition of leverage increases the size and extent of investment in
the bubble asset, as well as inflating the downside risk
• Extensive use of derivatives such as futures and options are also common features
of bubbles, providing further tools for investors to increase their exposure to the
bubble asset
• A significant new and/or disruptive technology, such as automobiles in the 1920s,
and the internet in the 1990s
• International “contagion” in which multiple countries are negatively affected by the
economic downturn following the crash
• You will now be directed to a series of websites that describe several other historic
bubbles
• Watch out for evidence of both the behavioral and non-behavioral factors that we
have discussed above as you read about bubbles throughout recent history
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Bubble-Crash Cycles throughout History

www.thebubblebubble.com/tulipmania/

www.thebubblebubble.com/south-sea-bubble/

www.thebubblebubble.com/railway-mania/

www.thebubblebubble.com/1929-crash/

www.thebubblebubble.com/dotcom-bubble/

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