a).

Introduction

The 2007-2010 global financial crisis is now well behind (Blackburn, 2008).  Many years will have to pass before a complete account of the crisis emerges. Economists and other interested professionals will have to wait for the necessary data for that understanding. This is not to say that no attempts have been made to explain the crisis. Indeed, there are already several papers explaining the causes of the crisis. Several of these papers have also recommended possible ways to prevent a recurrence in the future. It will not escape the eyes of a keen observer that many of the accounts of the 2007-2010 crisis focus on financial/economic explanations. The classic narrative has been that the sub-prime mortgage crisis in the U.S eventually led to a global financial crisis. While focusing on financial/economic factors to explain the crisis is unavoidable, such a singular focus is misleading as finance does not operate independent of other phenomena. It would be highly illuminating to borrow from other disciplines in accounting for the crisis. Other disciplines, especially psychology, can offer supplementary explanations of the crisis.

Efficient Market Hypothesis

Accounts of the 2007-10 financial crisis that solely focus on financial aspects stem from the efficient market hypothesis (EMH). Market efficiency remains a controversial issue in the world of finance and investments (Jordan & Miller, 2009). At the core of the market efficiency debate is whether it is possible for anyone to consistently beat the market (Jordan & Miller, 2009). Market efficiency assumes that no one can consistently beat the market. The EMH holds that organised financial markets are efficient. The London Stock Exchange (LSE) is an example of an organised financial market (Brealey, Myers& Allen, 2011).

Market efficiency was an unexpected discovery in 1953 by Maurice Kendall who was a British statistician (Brealey, Myers & Allen, 2011). He was investigating the behaviour of stock and commodity prices and had expected to find some regular pattern. It, however, turned out that this was not the case as each series appeared to wander. The term ‘random walk’ has come to stand for this irregular pattern in financial markets.  It simply refers to a situation in which one cannot depend on past actions to predict future steps and directions (Malkiel, 1999).

There are three conditions necessary for a financial market to be efficient. First, investors in that market must be rational (Jordan & Miller, 2009). Rationality as used in this context only refers to the fact that investors will never overvalue or undervalue any financial asset given the information that they possess. In the event that all investors are rational, it would never be possible for any one of them to earn excess returns. Even in cases where this economic condition of rationality does not exist among all investors, it is further assumed that deviations from rationality occur independently. Put another way, market efficiency can cancel out the effects of irrational investors acting in different directions. Lastly, arbitrage is another economic condition that ensures that the market remains efficient. Even when only a small group of investors in the market are rational, the market would still remain efficient (Jordan & Miller, 2009). These few rational investors would often identify arbitrage opportunities and correct them as they compete for them. The net effect is that arbitrage opportunities can never endure for long in the market.

Forms of market efficiency

It is important to note that saying that a market is efficient is not an endorsement of efficiency in all senses of the word. Efficiency in this sense is limited to only in respect to certain kinds of information (Jordan & Miller, 2009). A market is efficient with respect to some information if that information is not relevant in earning an excess positive return (Jordan & Miller, 2009). There are three types of information that are often used to define types of market efficiency: weak, semistrong, and strong. The set of information in strong-form market efficiency also includes the set of information in the semi-strong- form of market efficiency and this in turn include information set in weak-form market efficiency.

When a market is strong-form efficient, it implies that no information of any kind, whether public or private, can help an investor to earn excess positive returns. Market efficiency debate often ignores this form of efficiency because the possession of some non public information would clearly enable some investors to earn excess positive returns. It should, however, be noted that such kind of information would often be considered as insider information whose use to beat the market is criminal (Jordan & Miller, 2009).

With respect to a semi-strong form of market efficiency, all publicly available information is of no use in earning excess positive returns(Jordan & Miller,2009).It follows from this that the fundamental analysis conducted by most investment analysts is not helpful in beating the market. It is important to note that a strong-form efficient market is essentially also semi-strong from efficient.

Lastly, a weak-form efficient market is one in which past prices and volume data are not relevant in beating the market (Brealey, Myers & Allen, 2011). Thus, performing technical analyses is of no value in trying to beat the market. It should also be noted that a semi-strong form efficient market is essentially also weak form.

The 2007-2010 crisis: An EMH anomaly

Commentators cite the 2007-2010 financial crisis as an example of a bubble that eventually burst (Jordan & Miller, 2009). By definition, a bubble is a situation in which asset prices rise beyond what a normal and rational analysis would suggest. Bubbles do eventually pop given that they are not based on fundamental values. Bubbles pop in a crash which is simply the sudden drop in asset prices. The two are associated with each other such that a crash always follows a bubble. The latter lasts but longer than the other although the after effects of the former may continue for several years. The history of financial markets is replete with several bubbles and crashes.

The first of these bubbles and crashes occurred in 1929. By July 8, 1932, the United States (U.S) Dow Jones Industrial Average (DJIA) had a decline of about 90 percent. It took several years for DJIA to ever reach its previous high levels in 1929. There was also another bubble and crash in 1987, the Asian crash in the 1990s and the ‘dot-com’ bubble and crash at the turn of the century.

The beginning of the bubble

The immediate cause of the crisis was the sub prime mortgage crisis in the U.S (Basu, 2009).Following the dot com bubble at the beginning of the century, the U.S Federal Reserve begun to pursue an easy monetary policy. The Fed lowered its base lending rate to stimulate the real economy. This easy monetary policy had the effect of increasing the supply of money in the economy (Nissanke, 2009). Liquidity was also enhanced by the savings glut in emerging countries like China. Investors in those countries were looking for a place to invest their excess capital. They found the U.S financial market to be an appropriate place. Excess liquidity prompted growth in consumer credit. Of particular significance was the growth in mortgage lending.

Easy availability of mortgage lending in the U.S and other countries in Europe in turn led to a housing boom in these countries. In the case of the U.S, there was some toxic element in the boom as some of the mortgages were sub prime. With excess liquidity at their disposal, mortgage lenders were aggressively pursuing people to lend to (Nissanke, 2009). Many of the people who ended up with mortgage loans during this housing boom would never have qualified for such loans in the first place. Subjected to aggressive marketing campaigns, low income people who could not even afford down payments ended up with mortgages they could ill afford. The mortgages would have flexible rates with reset clauses in one or two years. Upon the adjustment of interest rates upwards or on the reset clauses coming into effect, many people defaulted on their mortgage payments (Nissanke, 2009).

The sub prime mortgage problem would not have affected many parts of the world economy were it contained only within the housing sector. This was, however not the case as these mortgage loans were repackaged in highly securitised products. Thus, there were collaterised debt obligations (CDOs). The innovative financial instruments emerging from this securitisation of underlying assets were then sold in both the financial markets and over the counter.

Lax regulatory policies were also responsible for the crisis. Beginning in 1982, U.S and the United Kingdom governments begun to loosen regulation of the financial markets. This move towards less and less regulations was informed by a belief that the markets were efficient (The Turner Review, 2009). The situation was made worse by the structure of executive compensation schemes in many financial institutions.  With a promise of huge bonuses and stock options, many of these financial institutions engaged in excessive risk taking. Potential default risks of the sub prime mortgage products were either deliberately overlooked and they were just incapable of being detected given the complexity of these products (Nissanke, 2009).

Lessons from Psychology

Critics of the EMH have tried to present evidence of cases in which fundamentals can no longer justify asset prices in the financial markets (Brealey & Myers, 2009). While one can not point out with any degree of certainty whether the market prices are actually unsupported by fundamentals, price appreciations that accompany bubbles are not easy to justify by the outlook for profits. Every investor seems to be caught up in the belief that they too can make a killing from the rising prices. Finance as it currently stands seems incapable of explaining the phenomenon of bubbles. This has prompted researchers to look for answers in other fields like psychology in attempting to account for bubbles.

Behavioural finance is the name of the new line of research that incorporates insights from psychology to explain anomalies in finance such as bubbles (Brealey & Myers, 2009). This field of research proceeds from the premise that people are not always rational all the time. Attitudes toward risk and beliefs about probabilities are the two reasons why investors may sometimes become irrational (Brealey & Myers, 2009).  With respect to the first, psychological theory holds that people are averse to a sure loss. They are also vulnerable to excessive optimist just as they are likely to commit extrapolation biases (Szyszka, 2011).

Even if there were some irrational investors in the market, one could argue that many professional investors in the same market can still exploit arbitrage opportunities. This in turn forces asset prices to go back to their fundamental values in line with the EMH (Brealey & Myers, 2009). Arbitrage is, however, subject to several limits. For one, arbitrageurs must contend with transaction costs which may eliminate the incentive to act on an arbitrage opportunity. Secondly, some trades are just difficult to execute. This presents the risk that asset prices may sometimes diverge before they converge. This situation was illustrated in 2008 when some fund managers holding Volkswagen (VW) decided to sell them short with the expectation of buying them back when prices went down.  Porsche eventually announced that it had acquired around 74% of VW. The announcement saw VW share prices raise so high leaving the affected funds to incur huge losses.

Given that there are limits to arbitrage, there is always a room for individual investors coming into the market with their own biases which force the market prices to drift from fundamentals (Brealey & Myers, 2009). This was the case in the build up to the U.S sub prime mortgage crisis.  Suffering from the extrapolation bias, home buyers were overconfident that the values of their houses were always going to increase. The originators of these mortgages were also caught up in the frenzy by thinking the housing boom was always going to continue.

Apart from the inbuilt investor biases, incentive problems were also responsible for the crisis. These incentives can interfere with rational focus on fundamentals (Dowd, 2009). The housing boom and eventual crash partly arose because banks, credit rating agencies as well as other financial institutions had distorted incentives (Brealey & Myers, 2009).

Mortgage borrowers in the U.S had an incentive to engage in risky borrowing as they could profit from the increase in their home values. In contrast, the penalties for defaulting on mortgage payments were very minimal. In the build up to the crisis, houses somehow ceased to be seen as homes. People started to see their houses as profitable opportunities. This is illustrated by the fact that some people were taking second or even third mortgages when and selling off their homes when prices rose (Shefrin, 2009). This incentive was enhanced by the fact that the sub prime borrowers did not even have to put in any deposit.

On their part, banks were willing to lend to sub prime borrowers because they stood to earn upfront fees in originating the mortgage loans (Brealey & Myers, 2009). The incentive to overlook the risk of default was provided by the ability to repackage the mortgage debts and sell them off. Buyers of these repackaged mortgage debts in turn assumed that they were safe as the rating agencies stamped them as such.

Rating agencies were themselves not immune from the psychological problems encountered by other participants. The fact that investment banks paid these agencies to rate the securities created an agency problem. Both rating agencies found that it was in their interest to pronounce the risky securities as safe. As an illustration, Moody’s introduced a new rating model in 2004(Shefrin, 2009). This new model made it much easier for securities firms to sell repackaged sub prime mortgages.  Standard & Poor’s(S&P) also changed its model a few days after Moody’s.

Governments were also responsible in a number of ways. For one, governments encouraged consumer lending in the mortgage industry. The role of the U.S government was particularly evident in its involvement with Fannie Mae and Freddie Mac which enjoyed government credit backup (Brealey & Myers, 2009). Many of the sub prime mortgages were sold to these two corporations. In addition, viewing some of the financial as too big to fail encouraged many of those institutions to engage in excessive risk taking. The UK government did this by bailing out Northern Rock.

Conclusion

Classical financial theory insists on fundamentals to explain economic phenomena. Such explanations are always sound when the Efficient Market Hypothesis (EMH) holds. The recent financial crisis was an example of a situation in which the hypothesis seems not to hold. By relying on concepts from behavioural finance, the paper has shown that accounts of the crisis should not be limited to finance.

 

 

 

 

 

 

 

 

 

 

 

 

 

b).

Introduction

September 15, 2008 is the day Lehman Brothers (LB) filed for bankruptcy protection. Earlier on, Bear Stearns had been rescued when the government organised its acquisition by JP Morgan Chase (Financial Crisis Inquiry Commission, 2011). Accounts of the failure of Lehman fall within the general accounts of the 2007-2010 financial crises.As already noted in alternative accounts of the crisis, a majority of those accounts focus on the field of finance. Alone, the field of finance cannot adequately explain the failure of financial institutions like Lehman.  Like accounts of the 2007-10 crisis, finance alone would not be adequate in explaining the failure of Lehman. Various psychological factors were responsible for the failure of this investment bank. A confluence of psychological phenomena was responsible for errors in judgement which led to the failure of Lehman as well as other financial institutions during the crisis. Those psychological mistakes were committed both by Lehman Brothers and other players in the financial sector.

Psychology of risk

The psychology of risk encompasses a number of concepts. Prospect theory is one of these concepts. The theory departs from the conventional assumption that economic decisions are always rational (Shefrin, 2008). At its core is the assertion that people are generally more concerned with the prospect of losing than with making gains. In contrast, rational investors would tend to focus o n the overall effect of a decision on their wealth. Such investors weigh the individual pieces of gains and losses in net terms.

Frame dependence is another psychological term that applies to investors. The idea behind the concept is that the manner of presentation influences the way people respond to a problem. Thus, two different but equivalent presentations of an investment problem will elicit inconsistent reactions from investors. This idea is inconsistent with the belief among some that frames are transparent making it possible for people to see through them.

Lastly for the present purposes, moral hazard and agency issues also affect the way people make decisions. Moral hazard is the tendency for people to engage in risky behaviour when the negative consequences of their behaviour are shifted to other people (Dowd, 2009). This situation was very common during the crisis. The various parties in the crisis were guilty of these and other psychological errors.

Mistakes made by Lehman

Events leading to the failure of Lehman can be seen as process failures that were unable to stem psychological biases in decision making (Shefrin, 2008). These biases were present in many of the decisions made at Lehman with regards to sub prime mortgages as well as derivatives. An organisation must have adequate processes in the area of planning, standards, incentives as well as information sharing (Shefrin, 2008). Such processes protects against behavioural vulnerabilities.

Planning mistakes

The growth strategy pursued by Lehman ensured that the company generated huge short-term accounting profits. At a time when the sub prime mortgage crisis was already taking a toll on investment banks, senior executives at Lehman still saw an opportunity to seek a countercyclical growth strategy (Valukas, 2010). In making this decision, Lehman was relying on its past in which it had been able to grow even in difficult conditions. For instance, the company was able to pursue growth in the 2001-2004 period when the U.S economy was facing the dot.com burst.

Evident from this planning was an extrapolation bias. Lehman was relying on the success of its growth strategy in the early 2000s to justify the new growth strategy during the sub prime crisis. This was a behavioural bias in reasoning (Valukas, 2010). There was no attempt on the part of Lehman to analyse the peculiarity of the two situations.  The growth strategy also exhibited overconfidence on the part of Lehman given that many other investment banks were reducing their businesses.

Risk standards

Good risk standards entails ensuring that there are accounting as well as other controls on what the various parties in an organisation can engage in (Shefrin, 2009). In opting for a higher growth business strategy, Lehman did not have prior risk standards in place. Acquiring assets to own as opposed to moving to third parties made the firm to internalise much of the attendant risk (Valukas, 2010). This risk profile was further compounded by the fact that Lehman financed its aggressive acquisition of long term assets with short-term debt. The official bankruptcy examiner reports that the firm had $ 700 billion of assets and $ 675 billion of liabilities with only $ 25 billion of equity. This represented a high degree of leverage.

The psychological explanation of this excessive risk taking can be seen from the perspective of heuristics. In solving complex tasks, people tend to develop simpler mental models of the situation. While such models are essential quick decision making, they can sometimes fraught with numerous errors. The reference point for Lehman was always its competitors. This extreme focus on competitors was a feature in the industry in which Lehman operated. This singular focus on what competitors were doing led to excessive risk taking by Lehman and other financial institutions.

Incentive systems at Lehman

The official U.S inquiry into the financial crisis (2011) noted the role played by incentive structures in bringing about the crisis. Two incentive structures were particularly responsible for the failure of financial institutions such as Lehman Brothers. In the first place, the way in which the investment banks were organised promoted a culture of risk taking. Investment banks had previously been organised as partnerships. This meant that each partner had the incentive to monitor the others as the partnership did not enjoy limited liability.

Allowing investment banks to organise as public limited companies since the 1980s and the 1990s altered all these incentive structures. It is not a particular phenomenon to Lehman as most investment banks at the time were organised in the same way. Enjoying the privilege of limited liability saw investment banks engage in buying risky mortgage backed securities due to the moral hazard problem. The incentive to engage in these risky activities as they always stood to benefit from such activities.  In contrast, they did not have to care much about the losses because these were borne by other people. The fact that investment banks sold off the risky assets to investors who stood to bear the risk of default made the situation even worse.

The second incentive that drove Lehman to bankruptcy was the compensation structure in the financial services industry. In an ideal setting, the management take compensation in return for maximising value to shareholders. The situation in the financial industry at the time was markedly different from this ideal position due to a number of flaws. In the first place, the compensation structure at Lehman had no regard for risk. By failing to account for risk, employees had an incentive to engage in ever risky transactions.

In addition, there was an undue focus on accounting profits in the compensation structure. Accounting profits are usually short-term in nature, thereby, providing an incentive for employees to focus on the short-term even if that would destroy value. A particular illustration was the $ 34 million paid to Richard Fuld, the Chief Executive Officer (CEO), of Lehman in 2007. Besides any other negative effects that they may have, compensation structures that focus too much on short term performance may tempt the management to manipulate numbers. Lehman was actually involved in this kind of manipulation through the so called Repo 105 and Repo 108. These were simply accounting tricks to help paint a rosy picture of Lehman’s books. Ordinary repurchase arrangements would have required Lehman to recognise losses and profits accruing from the transaction. Lehman was able to report improved leverage ratio through the repo transactions.

Mistakes by regulatory authorities

While Lehman and other financial institutions made psychological errors, these were not limited to the financial institutions. The regulatory agencies such as the Securities and Exchange Commission (SEC) as well as the Fed also played a role in the failure of Lehman and other financial institutions during the crisis.  The SEC was particularly responsible because it decided to raise leverage ratios for investment banks (Shefrin, 2009). This action allowed investment banks to take on more debt which turn led to increased exposure to risk.

Mistakes relating to standards

One of the most prominent failures of standards by the SEC related to the setting the leverage ratio. The regulator previously lacked the mandate to regulate investment banks. It took over this role upon its European counterpart taking the role (Shefrin, 2009). In return for accepting to be regulated by the SEC, the major investment banks accepted to comply with more regulations than would have been necessary. Relaxing the net capital rule with respect to the big investment banks was a clear illustration of overconfidence on the part of the regulator.  Thinking that it could now regulate the consolidated entity of a broker dealer and an investment bank was an unwarranted confidence on the part of the SEC that was not borne out in practice.

Incentives

The failure of Lehman is also a reflection of psychological mistakes by regulators in the form of pervasive incentives. For one, the Federal Reserve created the initial incentive for sub prime lending. By cutting the Federal funds rate early on in the 2000s, the Fed had the stage for excess liquidity in the financial sector. In the absence of adequate lending regulations, the increased liquidity provided the fodder for predatory lending.

In addition, the government considering some financial institutions as too big to fail created the notion that the government will always come to their rescue in times of trouble (Financial Crisis Inquiry Commission, 2011). This was demonstrated in the attitude of senior executives of Lehman who lobbied the government up to the last minute to bail it out.

Conclusion

The bankruptcy of Lehman Brothers is considered the biggest in the history of the U.S. Commentators continue to explain why this investment bank failed. A majority of those explanations have focused of classical financial theory. The above discussion has, however, shown that the failure of Lehman Brothers was as much because of psychological factors as it was fundamental.

 

References

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Blackburn, R. (2008).The Sub Prime Crisis. New Left Review, 50, 63-106.

Brealey, R.A., Myers, S.C., &Allen, F. (2011). Principles of Corporate Finance (10^th         Edn.).Avenue of the Americas, New York: McGraw-Hill Irwin.

Dowd, K. (2009).Moral Hazard and the Financial Crisis. CATO Journal, 29(1), 141-166.

Jordan,B.D.,& Miller,T.W.(2009). Fundamentals of Investments, valuation and management (5^th   Edn.).McGraw-Hill Irwin.

Malkiel,B.G.(1999). A Random Walk Down Wall Street: Including a Life Cycle Guide to    Personal Investing. London: W.W. Norton & Company.

Nissanke, M. (2009). The Global Financial Crisis and the Developing World: Transmission            Channels and Fall-outs for Industrial Development. United Nations Industrial Development Organisation Research and Statistics Branch Working Paper 06/09.

Shefrin, H.(2008). Ending the Management Illusion. New York: McGraw-Hill Irwin.

Shefrin,H.(2009).How Psychological Pitfalls Generated the Global Financial Crisis. Santa Clara University.

Szyszka,A.(2011).Behavioural Anatomy of the Financial Crisis. Journal of Centrum Cathedra,     121-135.

The Turner Review (2009). A Regulatory Response to the Global Banking Crisis. Financial          Services Authority.

United States Financial Crisis Inquiry Commission (2011). Final Report of the National     Commission on the Causes of the Financial and Economic Crisis in the United States.

Valukas,A.R.(2010). Examiners Report in re Lehman Brothers Holdings Inc. Et al v. Debtors.       United States Bankruptcy Court Southern District of New York.

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