Regarding Investment Analysis.? Most importantly Behavioral Finance.??

Question

I have a guaranteed question that is gonna be on my test, the question is.

How can Behavioral Finance solve the subprime mortgage problem.?

Answer 1

I would say that behavioral finance would help understand why even the shrewdest of investors (institutional hedge fund and other) were willing to blind themselves to the additional risk that they should have known they were taking on by investing in the CDO garbage being peddled to them.   Why were they willing to take on lower risk adjusted returns?  it defies logic.  was it b/c they were playing w/other people's money, thus increasing their risk tolerance?  i can't think of any really poignant questions, but i'm sure someone smarter than me can.

Answer 2

Your question is how should behavioral finance deal with the sub-prime mortgage problem.  The question, since behavioral finance is really a study of human behavior and its consequences without making judgment to act, should be restated as "How did human behavior cause the sub-prime mortgage problem and what consequences do the people involved face?"

You can state the problem like this:  Home buyers bought houses with the expectation of a substantial future return on their purchase.  This led to demand exceeding supply, resulting in price increases.  Further price increases drew in more people because they saw a house as an investment with return, not an item with utility (shelter).  Eventually, this led to irrational return expectations and the eventual collapse.

The consequence is home buyers risk owning a house worth less than they paid for it and lenders get stuck with houses and no buyers.  The question of how to fix the problem assumes someone will take action to fix it.  The best solution is to let the consequences of irrational behavior run their course (home buyers get stuck with an upside down house and lenders get stuck with houses).  The alternate solution is to have someone face the consequence of another person's bad decision.  An example of this is a government bailout (tax payer assumes the consequence of another person's action).

Lenders do not face the full risk of foreclosure because they packaged the loans into collateralized debt and sold them to investors.  Collateralized debt investors, not the lenders, may not receive payments from sub-prime borrowers.