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Information Cascading in the 2007 Financial Crisis

Information cascades have transformed the way that we make decisions. In formal terms, this cascade forms when a person in a group chooses to make a decision based on the previous actions of someone that he or she trusts. Cascades occur often in social networks and in advertisements, such as whether someone should attend a Facebook event based on its attendance, or whether a consumer should buy a product based on its online reviews. We now ask the question of information cascading regarding economics: did information cascading play a significant role in the financial crisis of 2007?

First off, the great recession was mainly caused by the subprime mortgage crisis. This crisis was a banking emergency that occurred because of inflation in home prices, leading to many foreclosures and household debt. This problem “temmed from an earlier expansion of mortgage credit, including to borrowers who previously would have had difficulty getting mortgages, which both contributed to and was facilitated by rapidly rising home prices” (Duca). Several years before the recession, high-risk mortgages became available to lenders who, in the past, could not obtain mortgages because of their below-average credit scores. When these high-risk borrowers couldn’t make their loan payments, they either sold their homes for profit and then paid off their mortgages with that money, or they borrowed even more money. This plan seemed to be foolproof, since there was a huge rise in home prices between 1997 and 2004 (Sunstein). However, once housing prices peaked, mortgage debt rose exponentially for both lenders and investors, and many mortgage lenders such a New Century Financial Corp. began filing for bankruptcy.

Looking at the trend from 1997 to 2004, many buyers thought that using high-risk mortgage loans to buy homes was profitable because the price of homes increase over time. In 2005, Shiller and Karl Case conducted a survey among San Francisco home buyers and found that “their baseless optimism was based on two factors: salient price increases in the recent past and the apparent, and contagious, optimism of other people” (Sunstein). Looking at these surveys, many people decided to buy homes because they saw the success of others, and thus they wanted to gain profit from mortgages as well. Answering the previous question that was asked: yes, information cascading did play a significant role in the financial crisis, because many people were led to borrowing money for mortgages that they could not pay back.

 

http://economistsview.typepad.com/economistsview/2008/10/informational-c.html

http://www.federalreservehistory.org/Events/DetailView/55

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