Dysfunctional Markets: A Spray of Prey Perspective

Abstract

We revisit the theory of financial crises using a predator-prey metaphor, highlighting the relationship between greed, risk aversion and debt accumulation and aggregating concepts from economics, finance and psychology. We argue that regulations that are implemented inefficiently, with weak enforcement or at the wrong time can have deleterious effects on the market, worsening the ailment they initially intended to correct and leaving a spray of prey in their wake. To illustrate our hypothesis, we examine the role of regulations in the years leading up to and during the Global Financial Crisis (GFC) in the United States, when the Federal Reserve tried to restrain the over-heated housing market propelled by the predatory mortgage frenzy and the increased use of securitization in risk-hiding financial tools such as Collateralized Debt Obligations (CDOs). Our results indicate that deleterious government interventions may act as a chemotherapy of sorts, causing harm followed by a slow recovery. This understanding can help governments draft better regulations to lower market frictions and better protect investors.

Keywords:

• risk aversion
• predation
• regulations
• contagion
• debt trap

JEL Classification Codes:

• G01
• G18
• G21
• G40
• H31
• H63

Notes

1 Wallison and Pinto (2010) argue that the Dobb-Frank Act allowed the substitution of the Federal Housing Administration (FHA) by Fannie Mae and Freddie Mac as the main provider of subprime mortgages. By their estimation, the U.S. government sponsored no less than 27 million subprime mortgages.

2 The U.S. government is not the only one at fault. Authors note that other governments have had failures as well (Glaeser and Shleifer 2001).

3  U.S. Census Bureau (https://www.census.gov/library/publications/2007/compendia/statab/127ed/banking-finance-insurance.html); World Bank (https://data.worldbank.org/indicator/NY.GDP.PCAP.CD). Accessed February 1, 2019.

4 Bloomberg. https://www.bloomberg.com/news/articles/2008-10-13/subprime-collapse-to-global-financial-meltdown-timeline. Accessed Feb. 1, 2019.

5 To that effect, Stiglitz (2009) mentions: “Thus, the notion that markets, by themselves, lead to efficient outcomes has, today, no theoretical justification: no one believes that the conditions under which that statement is true are satisfied.”

6 The Glass-Steagall Act meant to separate commercial from investment banking, developed to fight the Great Depression.

7 See also: Hellwig (2009), Reinhart and Rogoff (2009), and Priewe (2010).

8 Federal Reserve Bank of St. Louis. See https://fred.stlouisfed.org/series/INTDSRUSM193N. Accessed February 1, 2018.

9 From June 2004 to June 2006, rates rose steadily from 1.00% to 5.25%, and then stood still for a year. The Federal Reserve began lowering its rates in September 2007. While the interest rate was set in large part to target inflation (Saunders and Cornett 2014; Veronesi 2010); therefore, it certainly encouraged borrowing. By December 2015, the target rate was between 0.00–0.25%, the lowest in the Fed’s history, at least in part resulting from the aftermaths of the GFC. (https://www.federalreserve.gov/monetarypolicy/openmarket.htm). Accessed June, Sept., Dec. 2019, and January 2020.

10 We are using the phrase “utility maximization” to refer to market agents acting in their own interest. Although our framework could be used to analyze traditional utility maximization problems, it includes psychological constructs such as deception, greed, and fear, which often violates assumptions of mainstream economics (Huck, Mavoori, and Mesly 2019).

11 Specifically, these include threats, collusion, resources control inclusion withdrawal, false information, easy credit, incentives, lawsuits, and regulatory agencies (Djankov, Glaeser, La Porta, Lopez-de-Silane, and Shleifer 2003).

12 Academics have noted that older people are fooled more easily because of cognitive biases (Mather and Carstensen 2005) or lower capacities (Charles and Piazza 2009) while younger people are more naïve because they have less experience.

13 Eighty percent of fraud victims were aged sixty-five years or more (U.S. Federal Trade Commission 2001; Yoon et al. 2005).

14 The toxicity of the GFC ecosystem is exemplified by Razin and Rosefielde (2011): “Richard Bowen, III testified to the Financial Crisis Inquiry Commission that mortgage underwriting standards collapsed in the final years of the U.S. housing bubble (2006–2007). Sixty percent of mortgages purchased by Citicorp from some 1,600 mortgage companies were defective. Clayton Holdings reported in parallel testimony that only 54 percent of mortgage loans met their originators’ underwriting standards.”

15 U.S. Financial Crisis Inquiry Commission (https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf). Accessed February 1, 2017.

16 A variety of terms in the literature roughly describe the same phenomenon: herding (Dass, Massa, and Patgiri 2008), “keeping up with the Joneses” (Dupor and Liu 2003), or the bandwagon effect (Granovetter and Soong 1986).

17 Razin and Rosefielde (2011) cited an erroneous belief that structural deficits promoted accelerated economic growth.

18 See, for example, Glaeser and Shleifer (2001): “Subversion includes such techniques as intimidating judges and regulators, bribing them, and using delay tactics to postpone a trial or a liability payment. By expending sufficient resources on subversion of justice, the potential violator can avoid either regulatory compliance or a liability payment.”

19 Similar comparisons can be done made with other countries. For example, Glaeser, Johnson, and Shleifer (2001) show that 1900’s Poland and the Czech Republic differed sharply, with the latter sustaining the collapse of securities markets following a policy of laissez-faire to securities regulation.

20 Statistics Canada (https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=2110017501); Federal Deposit Insurance Corporation (https://www.fdic.gov/news/board/2018/2018-12-18-notice-sum-i-fr.pdf), accessed June 2018; U.S. Securities and Exchange Commission (https://www.sec.gov/help/foiadocsbdfoiahtm.html), accessed December 2018.

21 U.S. Mortgage Bankers Association (https://www.mba.org/news-research-and-resources/research-and-economics/single-family-research/national-delinquency-survey); Canadian Bankers Association (https://cba.ca/Assets/CBA/Documents/Files/Article%20Category/PDF/stat_mortgage_en.pdf). Accessed September 5, 2018.

22 Igan, Mishra, and Tressel (2011).

23 https://www.federalreserve.gov/consumerscommunities/cra_about.htm. Accessed Jan. 30, 2020.

24 Passed by the U.S. Senate on May 25, 2006, and soon signed into law, it imposed a huge debt on U.S. taxpayers.

Additional information

Notes on contributors

Olivier Mesly

Professor Olivier Mesly is an associate professor at ICN School of Business in Nancy and guest professor at University of Lorraine. He is a member of the Centre Européen de Recherche en Économie Financière et Gestion des Entreprises (CEREFIGE).

David W. Shanafelt

David W. Shanafelt is a researcher at the Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement (INRAE), as a member of the Bureau d’Économie Théorique et Appliquée (BETA). He maintains affiliations with the Université de Lorraine, Université de Strasbourg, AgroParis Tech, and the Centre national de la Recherche Scientifique (CNRS).

Nicolas Huck

Nicolas Huck is an associate professor at ICN School of Business in Nancy. He is a member of the Centre Européen de Recherche en Économie Financière et Gestion des Entreprises (CEREFIGE).