From the Desk of Chief Editor

Human 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.]

Introduction

The so-called subprime crisis in the United States of America that became a
reality with the burst of the home mortgage bubble has had its different sub-phases and
financial sector of the country is in real trouble. Though banks now find it a bit easy with
liberal central bank support, inter-bank lending rates are very high. The asset-based
commercial 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 the
worldwide remaining exposure to subprime loans at USD 380 billion and this is
excluding off-balance-sheet vehicles1.
The fear of recession in the US is now in people’s mind and one effect of this is
the worries about the deterioration in the climate of credit. Commercial property, car

1
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't
follow the same course."

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loans, home loan and credit card debts – all look very much precarious. All these cast
their shadow on the complex cascade derivative structure in the Wall Street only to
reinforce the question that how creditworthy all these credit ratings are! Why all these
had 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 loan
foreclosures creating a shock wave across the economic spectrum of the USA and beyond
and quickly made it a global crisis and that is the subprime mortgage financial crisis. The
genesis of the crisis started much before and in 2004 when Federal Reserve reduced the
interest rate to 1 per cent making the effective real rate a negative one if annual inflation
is 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 and
mostly neglected. Thus it is not the subprime rate that loan was granted, but it is the
quality of borrowers who would not otherwise be considered as prime borrowers having
enough income streams in command to repay the debt. Hence the name subprime
mortgage has come.
The crisis started with the bursting of the housing bubble and high default rates on
subprime rates and other mortgage loans made to high-risk borrowers with lower
incomes. Again, loan incentives including ‘interest-only’ repayment terms and low initial
interest 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 the
USA 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 prices
started to fall in many parts of the country and refinancing became very difficult. But
meanwhile 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 rate
mortgages were 90 days into default or in foreclosure proceedings. The mortgage lenders
who retained the credit risk were the first to get the hit as borrowers became unable to

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make payments. Again debt went into securitization and many mortgage lenders to the
mortgage payments passed the rights to the mortgage payments and related credit risk to
third-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 interest
rates on loans. The liquidity in the markets reduced and even corporate found difficulty
to obtain funds through traditional routes including commercial papers. The full
explanation of the crisis depends both on historical links and the macroeconomic
management 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 such
thing has happened. It seems it is in the human behaviour pattern and some event is
required to give a spark to this trait of human mind. The explanation in psychology is that
a 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 lowest
denominator. Experimental evidence shows that an important reason why people tend to
imitate others under certain circumstances is that they assume that others have
information that justifies their action. This is described as “ herd behaviour” ( Banerjee,
1992; Bikhchandani et el, 1992; C Avery et el , 1998; Whybrow, 2005). Constructing a
model of herd behaviour Banerjee ( 1992) has shown that in a sequencial game, if the
first two players have chosen the same action, player 3 and all subsequent players will
ignore her information and start a herd which may become an irreversible one. Examples
of such behaviour are stock market bubble, riots, religious zealotry and real estate price
crash. Some specific societal conditions may help the growth of mania when it induces
human 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.

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 Tulip Mania:
Tulips were imported into Europe from Turkeyin mid 16th century and the flowers
soon gained popularity. The rare varieties of the flower were short in supply and demand
outstripped the supply soon. As a result price increased to such heights that by 1610 one
rare tulip bulb was considered as an acceptable dowry. As demand soared, ordinary
citizens found speculation of the tulip bulb as a way to riches. Netherlands , the largest
producer of the tulip flower, became the epicenter of the mania for tulips. People
mortgaged their houses even to buy the bulbs of tulips. Such was the force of the mania
and it became history2. Netherlands also suffered severely from an epidemic of bubonic
plague in first quarter of 17th century. Also the country got embroiled in the so-called
Thirty Years’ War that continued during 1618 to 1648, in which all major European
powers including Netherlands became involved3.

South Sea Bubble

Britain’s involvement in the war in new world colony ( America) in early part of
18th century led to huge government debt, and in 1711 Britain proposed a deal to a
financial institution, the South Sea Company (SSC), which would finance Britain’s debt
in return for 6 per cent interest. The Company was also given exclusive right to trade with
the colonies to which Company agreed because of the proximity of the South American
colonies. The Company instituted monopoly in slave trade. Moreover, it was planned that
Mexicans and South Americans would trade their gold and jewels for the wool and
clothing from Great Britain.
The SSC issued stocks to finance its operations and investors also saw the
monopoly status of SSC and started to buy the stocks in a big way in the expectation of
capital gains. The SSC saw the market and issued more stocks to satisfy the increasing
2
Is mania is the outcome of a particular societal situation? Such question has been pursued in the following
book: Peter C. Whybrow ( 2005)
3
The Thirty Years’ War [ 1618 – 1648 ] was fought mainly on the territory of today’s Germany and all major European
powers were involved in this. It all began as a religious conflict between Protestants and Catholics within the Holy
Roman Empire, it gradually developed into a general war as nations in Europe tried to take advantage of the continued
state of unrest in whole of Germany. Mercenary armies were extensively used in this war and major impact was the
devastation of the entire region. The war marked the continuation of the France – Habsburg [ the ruling House of
Spain] rivalry for the pre-eminence in Europe, and that led to direct war between France and Spain.

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demand for stocks. The time coincided with England’s industrial revolution and many
investors were attracted by the lavish corporate offices of SSC. The management team of
the latter started hyping the stocks to create illusions of the grandeur to the investors and
practiced speculations as the stock prices started skyrocketing. Meanwhile management
was involved in corruption as many within the organization tried to make money during
the stock- boom.
Seeing the market and results of the SSC other companies joined the market and
the same trend continued with extra energy. Meanwhile war started between Britain and
Spain in 1718 and the crisis led to a drastic reduction in profits of the SSC. Initially the
company tried to cover that by issuing more stocks, but could not save ultimately. The
bubble did burst and investors lost huge amount of money.

Florida Real Estate Craze, USA

In 1920 and thereafter farmers who wished to enjoy warm winter purchased plots
of lands in Florida. Soon they were followed by bankers from New York, who was eager
to enjoy vacation and also flaunt their new found wealth. At that time real estate could be
purchased on mortgage for only about 10 per cent down. This provided the financial
leverage for the boom. Bubble started as craze was built up. People saw acres of Florida
swampland going for higher prices and dirt and garbage were brought by trucks to fill up
the swampland into land for sale and to satisfy speculation. At the peak of the bubble
one-third of people at Miami consisted of real estate agents, and that also was not enough
as warning for impending danger. The real estate bubble was burst by a sudden hurricane
that destroyed many homes and caused extensive damage to property. Soon prices
collapsed and bankruptcies followed.

The Stock Scam in Bombay Stock Exchange

The second part of 1980s was not good for the stock market based in Bombay. In
early 1990s some brokerage houses started artificial jacking of stock prices to create
illusion among the investors about rapidly rising prices of the stocks. Investors poured

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money in stocks of companies, many of those were new entrants in the stock exchange.
Seeing the euphoria a large number of fictitious companies issued stocks to satisfy the
growing appetite of the investors. Some banks also got involved as they financed the
operations of both the investors and the brokers. The bubble was burst in 1992 with the
arrest of some big brokers for fraud and prices of stocks collapsed along with hundreds of
companies disappeared from the screen.

The above events of history have one common point and that is that human
behaviour creates the bubble that is formed on the wave of a mania or craze. This cannot
be restrained or stopped with logic or economic reasoning, and it has its end on its own.
Theories, particularly economic theories are built on the presumption of certain standard
behaviour pattern of individuals, and that too stylized individual. So whenever mania as
described above starts, theoretical understanding remains silent as helpless.

While historical events explain the nature of bubble origination from human behaviour,
there has been some macroeconomic perspective that has led to the situation leading to
the sub prime crisis in the USA.

Regime of Low Real Interest Rate

The interest rate is the result of the movements of both savings and investments at the
world level. During the period 1980 – 2005 there have been several swings of both
savings and investments in the world. Apart from the growth of gross national products in
many Asian countries, the relative price of oil had been important in the shift in the world
savings schedule during 1980 – 1983. Also empirical findings show that financial
development and demographic changes affect the savings rate4. Moreover, bequest
motive, change in life expectancy and elderly dependency ratio also have significant
impact on the savings ratio.

4
Bank of Canada ( March,2007)

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Some countries in Asia, specially India and China followed the successful export-oriented
economic model of Brazil and some Asian countries. While high value technology are
available from the developed world, a low-cost but efficient labour force with enough
capital inflow and aided by high-value technology made very high economic growth
possible. The huge export of commodities from these developing countries to The USA
and Europe reduced the inflation expectations. Again this also flattened labour
compensation in the developed countries and thus restrained another source of
inflationary expectation. The reduced inflation expectation at the global level induced the
global real interest rates to decline.

Since 1990 savings ratio increased significantly mainly due to impressive growth with
very high savings in China and also Japan. China now saves more than 40 per cent of her
income, while Japanese savings , in spite of a significant fall in early 2000, is about 23
per cent, which is quite high by western standard. Also some Asian countries are having
high savings rate. All these explain the availability of high volume of investible funds in
the world in post 1990 period.

Empirical research ( Bank of Canada, 2007) also reveals that the variables
affecting investment demand during the period 1980 – 2005 had been labour force
growth, stock market returns, volatility in the capital market and financial liberalization.
Again, desired savings had been affected by age structure of population, temporary
income, government deficits and level of financial development.

From 1990 onwards there had been a slowing of investment activities in the world
in general and the USA in particular. Growth of labour force had been slow all through
1990s and that affected the investment demand negatively. The oil price shock had been
another variable affecting the investment demand.

Since 1990 there has been a marked decline in the global real interest rates and
this had been the outcome of global saving propensities had been higher than the
intention to invest. This is because consumption in the developing world had been a

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laggard compared to the explosive growth of income. The result is that the savings rate of
the developing world increased continuously so much so that it increased from 24 per
cent in 1999 to 33 per cent in 2007. Why the fractional value of marginal propensity to
consume in not-so-rich countries could not increase consumption along with surge in
income is an issue of research, but perhaps structural problems and policies of the
government had been the major determinants of the increase in savings in these countries.
One example in China as in spite of explosive growth of income, consumption does not
increase significantly and savings rate touched 40 per cent.

There are two important aspects of the increase in the savings rates in some
regions of the world. First, almost all the increase in savings in these countries/ regions
has been matched by a fall in the savings rates in the United States. Second, some
countries in Asia and Middle East are accumulating international reserves in a big way,
and most of the increased savings had been transformed into dollar reserves in the
international reserves.
From the perspective of the United States the surge in savings in some countries
meant inflow of capital in the US. After netting US total investment demand, both public
and private, from US savings, the US has a demand for savings from the rest of the
world, and it is downward sloping with respect to real interest rate. The lower the real
interest rate the country faces, the less the country wants to save and more it wants to
invest. If there is scope for profitable investment at the margin, a decline in real interest
rate will induce a large change in the demand for international savings.

The United States started facing the economic problems emanating from the Iraq
war and economic growth slackened in the year 2003. The decline of investment
intention in the country also had been associated with more or less same situation in some
other parts of the developed world. This situation induced the Federal Reserve to reduce
interest rate. Again inflation at that time was at its lower level, but very low interest rate
made the real interest rate near zero, if not negative. All these led to the equity premiums
and real-estate capitalization being arbitraged lower by the fall in global real interest
rates. Asset prices moved in stratosphere and share prices also surged higher and higher.

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The value of equities traded in the world’s principal stock exchanges had been more that
USD 50 trillion in 2006, and that was double the figure that had been in 2002. The world
also witnessed a major housing bubble in the sharply rising home prices, and the US also
became embroiled in it. Monetary and fiscal policies could not stop this bubble as built in
global economic forces appeared to gained effective control of the dynamics of the
bubble. So the world had to wait to see the automaticity of the burst of the housing
bubble.

Conclusion
The subprime crisis has taught us several lessons. First, somewhere in the
evolution of the financial crisis when cobweb of financial engineering had been creating
the securitization maze, the relation between the short term real interest rate and the long
term rate got snapped. Second, the resources of the central banks were flooded with
arbitragable assets like equities, bonds, real estate and other financial assets created
through financial engineering. This aspect constrained the power of the central banks to
articulate monetary policies to halt the bubble. Third, once the human mania starts on any
issue, whether the buying of one tulip flower, or a real estate in Bombay- Thane -Pune
region, or company stocks, fiscal-monetary policy mix becomes helpless, and society
sees the bubble burst with all its serious economic repercussions. Prevention is better, and
that requires proper dissemination of knowledge regarding the effects of mania.

References:

Avery, C and P. Zemsky, Multidimensional Uncertainty and Herd Behaviour in Financial

Markets, American Economic Review, 88, 1998, pp. 724 – 748 .

Banerjee, A. V., A Simple Model of Herd Behaviour, The Quarterly Journal Of

Economics, 107 ( 3), 1992, pp. 797 – 817 .

Bank of Canada, World Real Interest Rates: A Global Savings and Investment
Perspective, Working Paper No. 2007 – 16 , march, 2007.

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Bikhchandani, S., D. Hirshleifer and I Welch, A Theory of Fad, Fashion, Custom, and
Cultural Change as Informational Cascade, Journal of Political Economy, 100 (5), 1992,
pp. 992 – 1026 .

Whybrow, Peter C., American Mania: When More is not Enough, W W Norton and
Company, 2005.

Sukumar Nandi

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