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Human Behaviour

Human Behaviour

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Published by Sukumar Nandi

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Published by: Sukumar Nandi on Mar 14, 2008
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From the Desk of Chief EditorHuman Behaviour, Financial Bubble and Lessons of History: A Perspective of Subprime Mortgage Crisis in USA
“It is the historian who has decided for his own reasons that Caesar’s crossing of that petty stream,the Rubicon, is a fact of history, whereas the crossing of the Rubicon by millions of other people before or since interests nobody at all”.[E. H. Carr, What is History?, Penguin Books, Harmondsworth, U.K.,1975, p.11.]
The so-called subprime crisis in the United States of America that became areality with the burst of the home mortgage bubble has had its different sub-phases andfinancial sector of the country is in real trouble. Though banks now find it a bit easy withliberal central bank support, inter-bank lending rates are very high. The asset-basedcommercial paper market experienced continuous decline in the last quarter of 2007. The bank crisis has been averted as USD 27 billion capital has flowed into the banking sector from sovereign wealth funds. The recipients of this fund include Merrill Lynch,Citigroup, Morgan Stanley, Goldman Sachs and Credit Suisse. But banks’ residential – mortgage problems are not over yet. Banks have already written off whopping sums over subprime mortgages, but they remain vulnerable to more hits. One estimate put theworldwide remaining exposure to subprime loans at USD 380 billion and this isexcluding off-balance-sheet vehicles
. The fear of recession in the US is now in people’s mind and one effect of this isthe worries about the deterioration in the climate of credit. Commercial property, car 
Wall Street Journal, 24 December, 2007. "It's now conventional wisdom that a housing bubble has burst.In fact, there were two bubbles, a housing bubble and a financing
 bubble. Each fueled the other, but they didn'tfollow the same course."
loans, home loan and credit card debts – all look very much precarious. All these casttheir shadow on the complex cascade derivative structure in the Wall Street only toreinforce the question that how creditworthy all these credit ratings are! Why all thesehad happened? The following paragraphs try to explain the incident.
The Perspective
The Fall of 2006 in the United States of America saw a sharp rise in home loanforeclosures creating a shock wave across the economic spectrum of the USA and beyondand quickly made it a global crisis and that is the subprime mortgage financial crisis. Thegenesis of the crisis started much before and in 2004 when Federal Reserve reduced theinterest rate to 1 per cent making the effective real rate a negative one if annual inflationis taken care of. This induced many people to take loan and invest in house purchase.Thus the craze for house purchase started and banks found it as easy business as credit portfolio started inflating. But in the process it is the risk that remained under-priced andmostly neglected. Thus it is not the subprime rate that loan was granted, but it is thequality of borrowers who would not otherwise be considered as prime borrowers havingenough income streams in command to repay the debt. Hence the name subprimemortgage has come.The crisis started with the bursting of the housing bubble and high default rates onsubprime rates and other mortgage loans made to high-risk borrowers with lower incomes. Again, loan incentives including ‘interest-only’ repayment terms and low initialinterest rate encouraged borrowers to take upon mortgages in the belief that they would be able to refinance at more favourable terms at later period. The housing prices in theUSA continued to increase during the period 2004- 2006 and refinancing was available.But every bubble has its life span and this was no exception. In 2006 housing pricesstarted to fall in many parts of the country and refinancing became very difficult. Butmeanwhile share of subprime mortgages had increased from 9 per cent in 1997 to 20 per cent in 2006. In October 2007, 16 per cent of the subprime loans with adjustable ratemortgages were 90 days into default or in foreclosure proceedings. The mortgage lenderswho retained the credit risk were the first to get the hit as borrowers became unable to2
make payments. Again debt went into securitization and many mortgage lenders to themortgage payments passed the rights to the mortgage payments and related credit risk tothird-party investors through the derivative instrument called mortgage-backed securities.The latter were mostly held by institutional investors and they incurred huge losses.In the whole process it is the risk associated with the elements of the portfolio of assets that remained underpriced. This issue remained neglected too. Once the results of keeping risk low-priced became clear and banks suffered losses, they increased interestrates on loans. The liquidity in the markets reduced and even corporate found difficultyto obtain funds through traditional routes including commercial papers. The fullexplanation of the crisis depends both on historical links and the macroeconomicmanagement of the country to which we now turn.
History of bubbles:
Craze for something unique is very common in human history and many a time suchthing has happened. It seems it is in the human behaviour pattern and some event isrequired to give a spark to this trait of human mind. The explanation in psychology is thata craze is an excessive fad or collective mania due to herd behaviour when the personality of the individual becomes subdued and emotion comes to its lowestdenominator. Experimental evidence shows that an important reason why people tend toimitate others under certain circumstances is that they assume that others haveinformation that justifies their action. This is described as “ herd behaviour” ( Banerjee,1992; Bikhchandani et el, 1992; C Avery et el , 1998; Whybrow, 2005). Constructing amodel of herd behaviour Banerjee ( 1992) has shown that in a sequencial game, if thefirst two players have chosen the same action, player 3 and all subsequent players willignore her information and start a herd which may become an irreversible one. Examplesof such behaviour are stock market bubble, riots, religious zealotry and real estate pricecrash. Some specific societal conditions may help the growth of mania when it induceshuman psychology in a particular way and this may result in a mania ( Whybrow, 2005).History is full of such incidents and we now turn to these cases.3

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