Markets and Behavior
What is a bubble?
When prices rise far above what something is really worth, because everyone expects them to keep rising.
What is a bank run?
When lots of people try to take their money out of a bank at the same time.
A mortgage broker earns a commission for every mortgage approved, even if the borrower later defaults. What problem does this create?
Misaligned incentives - the broker is rewarded for issuing loans rather than ensuring borrowers can repay them.When someone is rewarded for an action without being held responsible for its negative consequences.
Why did rising house prices encourage people to buy homes even when prices were becoming unsustainable?
They expected prices to keep rising and believed they could sell at a profit.
Why might a bank stop lending to other banks during a financial panic, even if it has money available?
It may fear that other banks will fail or be unable to repay their loans.
What is market efficiency?
The idea that market prices already reflect all available information.
What is contagion?
When one bank’s trouble spreads to others, like a disease.
A bank sells its mortgages to investors instead of keeping them on its books. How does this change the bank’s incentives to check whether borrowers can repay?
The bank may have less incentive to carefully screen borrowers because it transfers some of the default risk to investors.
Why did banks have an incentive to issue risky mortgages if they could sell those loans to investors?
They could earn fees while transferring much of the risk to investors.
If one bank sells assets quickly to raise cash, how could this make the situation worse for other banks holding similar assets?
The sales push asset prices down, reducing the value of other banks’ holdings and potentially forcing them to sell too.
What is herd behavior?
When people follow the crowd instead of thinking for themselves.
What is systemic risk?
The risk that one failure could bring down the entire financial system.
A financial institution takes greater risks because it expects the government to cover some of its losses if it fails. What problem does this illustrate?
Moral hazard - the expectation of protection from losses encourages risk-taking.
How did falling house prices turn mortgage defaults into a larger financial crisis?
Borrowers lost home equity, defaults and foreclosures increased, and mortgage-backed securities lost value.
Why could the failure of one major financial institution threaten institutions that were not directly responsible for its losses?
Financial institutions are interconnected through lending, trading, and other contractual obligations.
What is speculative behavior?
When investors buy an asset because they expect its price to keep rising, helping push prices even higher.
What is a fire sale?
When someone is forced to sell assets quickly at low prices.
A rating agency is paid by the same banks whose mortgage-backed securities it evaluates. Why might this undermine the reliability of its ratings?
Conflict of interest - the agency’s financial relationship with the banks may compromise its independence.
Why did the collapse of the housing market hurt financial institutions that did not directly make mortgages?
Many institutions held mortgage-backed securities or were exposed to firms that held them.
Why might a government rescue a failing bank instead of allowing it to collapse?
Its failure could disrupt credit markets and spread losses throughout the financial system.
What is overconfidence?
he tendency to believe that your judgments or predictions are more accurate than they really are, potentially leading to risky investment decisions.
What is a vicious circle (feedback loop)?
Prices fall, so people sell, which makes prices fall more.
Why might banks that expect the government to rescue them during a crisis take greater risks before the crisis occurs?What is a government bailout?
They may expect taxpayers or the government to absorb some of the losses, reducing the consequences they personally face for taking excessive risks.
Why did falling house prices make it harder for homeowners to repay their mortgages or avoid foreclosure?
Some homeowners owed more on their mortgages than their homes were worth, and they could no longer sell or refinance their homes easily.
How could a financial crisis cause a recession even for businesses that had little direct exposure to mortgage-backed securities?
Banks reduce lending, consumers cut spending, and businesses struggle to finance operations and investment.