Information Cascade and the 2008 Financial Crisis
In this article, the author discusses how information cascade helped cause the housing crisis in 2008. In order to understand how this happened, it is important we first understand what structure was in place that allowed the 2008 financial crisis to occur in the first place. An economically stable family wants to buy a house and contacts a mortgage broker who in turn connects the family to a mortgage lender who then gives them a mortgage on their house. An investment banker contacts the mortgage lender and wants to buy their mortgage. Since the federal interest rate is at one percent after the dot com bubble, the investment banker borrows a ton of money and buys many additional mortgages and organizes all of it into something called a collateral debt obligation (CDO). CDOs are made up of all the mortgages mentioned previously but organized into different safety ratings depending on the likelihood of a homeowner defaulting on their mortgage. The riskier mortgages have a higher rate of return while the safer ones have a lower rate of return. Financial institutions organize mortgages like this in order to receive stamps of “AAA”, “BBB”, “CCC”, ratings from credit rating agencies. They can then sell triple A rated mortgages to risk adverse investors, and triple C rated mortgages to hedge funds and risk takers. This entire process makes everyone in the chain very rich, so much so that investors want more mortgages to buy. Thus, this increase in demand leads to mortgage brokers and mortgage lenders giving out mortgages to economically unstable families and individuals that have a high risk of defaulting on their mortgage called “sub-prime mortgages”.
This is where the problem of information cascade steps in and allowed the 2008 housing crisis to occur in the first place. Information cascade occurs when a person observes the actions of others and then – despite possible contradictions in his or her own private information – engages in the same acts. Since everyone in the previous chain was so fixated on making more money by giving out more mortgages, no one in the chain stopped to think whether giving out millions of subprime mortgages would have a consequence. In fact, they thought of sub-prime mortgages as a sort of “hot potato time bomb”. The moment a sub-prime mortgage was sold, it was the next person’s problem and so on. This led to everyone, from the mortgage broker, to the investors turning a blind eye and fixating on buying/selling subprime mortgages without looking at the consequences. Of course this all comes around when the millions and millions of sub-prime homeowner’s default on their mortgage. This causes an increase in housing supply and causes housing prices to fall drastically which eventually lead to widespread bankruptcy and the eventual government bailout.
http://economistsview.typepad.com/economistsview/2008/10/informational-c.html