Subprime Mortgage Crisis: The Result of an Information Cascade?
The ongoing recovery from the recent financial crisis in the US serves as evidence of some of the dangers of information cascades. Even today, the economy is sluggish despite steady improvements, and the Securities and Exchange Commission (S.E.C.) has continually investigated the roles that major U.S. investment banks played throughout the crisis. As mentioned in the referenced New York Times DealBook article (see link at the end of this blog entry), recently, the S.E.C. penalized Wells Fargo for $6.5 million in a settlement regarding Wells Fargo’s role during the crisis. The S.E.C. claimed that Wells Fargo failed to inform investors about “the nature and volatility of the underlying [mortgage-related] assets,” and also “failed to understand the true nature, risks and volatility” of their complex mortgage-backed securities. Indeed, this was common throughout the crisis. In The Big Short by Michael Lewis, Lewis mentioned that while the original intention of the creation of mortgage-backed securities (MBS) was to inject more capital into the housing market and make funds more accessible to homeowners, while decreasing the cost of funds for mortgage loan originators to obtain capital via the securitization process, the result was that certain investment banks, acting as intermediaries for packaging the loans into securities, found MBS to be a hugely profitable business, and therefore continued to increase the amount of MBS issuances. This would not have been so problematic if the underlying loans were mostly high quality; even if some loans were of lower quality, the structure of an MBS can diversify away some of that risk. However, there were many investment banks that chose to also include subprime loans in their MBS products, and this pattern of issuing low quality securities perceived to be of high quality (many rated AAA), combined with moral hazard and negligence of other agencies, led to the subsequent subprime mortgage crisis. Furthermore, rating agencies (one type of negligent agency) were using questionable security-rating models filled with loopholes to rate MBS products, and as a result, mistakenly rated intrinsically high-risk MBS products as investment grade (including many AAA). Therefore, it is no surprise that, as mentioned in the referenced DealBook article, Wells Fargo and many other investment banks both did not truly understand the nature of the underlying loans of the highly-complex MBS products they were issuing, and as a result, failed to properly inform investors of these risks.
The discussion above relates to the concepts of information-based reasoning and information cascades that we discussed in class. Information-based reasoning essentially states that we assume other people’s decisions to represent information conveyance, and because some of this information, whether truthful or not, may represent information that we were previously privy to, other people’s decisions affect our personal decisions. Furthermore, an information cascade, which is a long sequence of people all making the same decision regardless of whether their own information supports it, can result because the most recent person making the decision may assume that everyone before him had access to some information that led their decisions, and he might as well make the same decision because he believes there is a high probability that it’s the correct decision. Linking this to the referenced article, Wells Fargo may have observed other investment banks profiting largely from selling MBS products, and as a result, decided to enter the MBS business. As banks began to include larger proportions of subprime loans into MBS products, Wells Fargo presumably followed suit even if it was not well-informed or believed the practice to be harmful or immoral. Furthermore, even when the securitization process led to incomprehensibly complex MBS products, Wells Fargo continued to issue the securities even if they were unable to explain the details of the underlying mortgages, as well as their risks, to investors. Clearly, it was possible that Wells Fargo made their decision to participate in the MBS market primarily based on the participation of other banks, either because Wells Fargo deceptively believed the market to be sustainably profitable, which is in line with the decision of other banks to participate in the market, or Wells Fargo believed the other banks were better-informed in their decision to participate in the market, even if Wells Fargo believed the participation to be detrimental based on their own information. The information cascade resulting from banks, including Wells Fargo, deciding to participate in the MBS market and continuously issue large quantities of questionable-quality MBS securities (many “AAA” according to rating agencies), played a crucial role in the subprime mortgage crisis of 2007-2008.
-CW
Sources:
The Big Short by Michael Lewis