Summary of Psychology and the Financial Crisis of 2007-2008 by Nicholas Barberis

Barabris in this paper examines some of the psychological factors which contributed to the financial crisis of 2007-2008. The paper begins by presenting several explanations of the run up in housing prices which preceded the financial crisis by discussing several “beliefs based” and” investor preference” models. The author settles on the argument that households had over extrapolated past price behavior of housing too far in the future as the central reason for the bubble in the housing market. He believes that investors and homeowners took a relatively small sample of data on the housing market and its past returns and over-extrapolated these returns too far into the future. He furthers that the housing bubble could not have occurred with homeowners alone and ratings agencies and suppliers of credit were complicit to the formation of the housing bubble by similarly extrapolating housing prices too far in the future.

The author further examines how the formation of this bubble and its eventual burst had such a pronounced impact on the overall US banking system. He begins with an explanation of how banks were able to accumulate so much of this risky subprime linked debt on their balance sheets. The well -established argument of bad risk models and bad incentives to employees is presented. The author believes these 2 explanations meaningfully overlook another factor called cognitive dissonance – the idea that employees and risk managers at banks and rating agencies were able to convince themselves that the debt they were accumulating was not that risky, in order to overcome their own concerns about what they were doing . This allowed them to protect their own self-image while making them feel better about assigning AAA ratings or accumulating massive amounts of risk for their employers. This belief manipulation was driven by the relative complexity of subprime linked loans and the plausible sounding arguments that housing prices had always moved higher. Employees were unaware of the risks of these assets because they made a decision to ignore what they had been taught about the category either to protect their self-esteem or their lucrative income streams. Once the bubble did burst these