Blog

Wall Street no smarter than Mr and Mrs Average

Jim Riley

3rd September 2014

Lurid stories about the excesses in the UK housing market continue to proliferate. True, there is some evidence of a cooling, as the price rises tempt more sellers into the market and temporarily increase supply relative to demand. But at the same time we learn in the Sunday Times that the good burghers of Cobham enjoyed on average – on average! – an increase in the value of their homes of no less than £647,000 over the past twenty years. Other areas in the Home Counties saw similar huge capital gains.

The Bank of England is known to be concerned about the possibility of a new house price bubble, of prices being driven further and further away from levels which can be justified in terms of fundamental economic circumstances.

Such bubbles end in tears, and some readers may recall the dramatic collapse in prices which took place at the end of the so-called Lawson boom at the end of the 1980s. In many places, house prices did not regain theses peak levels until the early 2000s.

The real worry is that any such bubble would have damaging effects on the rest of the economy. The new buzz phrase in policy circles is 'macro prudential'. Central banks are now much more aware of the damage that shocks in just one sector can cause, as their effects cascade across the economy as a whole. And it was in the housing sector that the financial crisis began in the United States.

Much of the public outrage about the crisis rests on the belief that the incentive structures in financial institutions encouraged people to take huge risks, with no personal downside. Wall Street, it is alleged, knew about the risks of a financial collapse, but simply carried on securitising mortgages of ever decreasing quality.

A new paper in the American Economic Review undermines this widespread perception. Ing-Haw Cheng, of the Ivy League Dartmouth College, and colleagues from Michigan and Princeton analyse the personal home transaction data of managers in securitized finance in the period immediately before the housing crash. In other words, when they were buying and selling on their own accounts, using their own money, did they behave as if they were aware of the housing bubble and the looming crisis?

The conclusion is stark.

In general, these managers neither timed the market correctly, nor were they in any way cautious in their own transactions in the housing market. They seemed unaware of the overall problems in this market. Indeed, a sizeable proportion of securitisation agents were particularly aggressive in increasing their personal exposure to housing in the run up to the crash.

The problem, Cheng and colleagues conclude, was not the incentive structure. It was a problem of psychology. Company ethos fostered both over-optimism and groupthink. Different beliefs about the housing market were not encouraged. A massive divergence arose between the dominant narrative on Wall Street about the housing market, and what was actually happening to prices.

Monitoring beliefs seems crucial to avoiding the next crisis.

Jim Riley

Jim co-founded tutor2u alongside his twin brother Geoff! Jim is a well-known Business writer and presenter as well as being one of the UK's leading educational technology entrepreneurs.

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