decision making for leaders
MGT422: Decision-making for Leaders
MODULE 1: CASE
The Collapse of the Housing Bubble and the Mortgage Crisis
1.) From the viewpoint of expected utility theory, should this situation ever have developed in the first place?
The simple answer is no it should not have happened. Using the expected utility theory gives you the chance to make the best decision based on data. But as we all know no one can predict the future and it shows. The financial world has become more complex in the past two decades. Not so long ago, most mortgages were of the 30-year fixed-rate variety. Shopping was simple: find the lowest monthly payment. Now they come in countless forms. Even experts have trouble comparing them and a low initial monthly payment can be a misleading guide to total costs (and risks). A main cause of the mortgage crisis is that borrowers did not understand the terms of their loans. Even those who tried to read the fine print felt their eyes glazing over, especially after their mortgage broker assured them that they had an amazing deal. Yet growing complexity on the borrowers’ side was trivial compared with what was going on at the banks. Mortgages used to be held by the banks that initiated the loans. Now they are sliced into mortgage-backed securities, which include arcane derivative products. Many economists have argued that even if individual consumers suffer from bounded rationality, markets will be set right by specialists who can figure out even the most complex problem. But, as Mr. Greenspan now concedes, even these sophisticated investors got things badly wrong.
2. How did bounded rationality on the part of buyers and lenders contribute to the underlying causes of the housing crisis of 2008, which is still being felt today?
First we have to understand bounded rationality. It is the Concept that
MODULE 1: CASE
The Collapse of the Housing Bubble and the Mortgage Crisis
1.) From the viewpoint of expected utility theory, should this situation ever have developed in the first place?
The simple answer is no it should not have happened. Using the expected utility theory gives you the chance to make the best decision based on data. But as we all know no one can predict the future and it shows. The financial world has become more complex in the past two decades. Not so long ago, most mortgages were of the 30-year fixed-rate variety. Shopping was simple: find the lowest monthly payment. Now they come in countless forms. Even experts have trouble comparing them and a low initial monthly payment can be a misleading guide to total costs (and risks). A main cause of the mortgage crisis is that borrowers did not understand the terms of their loans. Even those who tried to read the fine print felt their eyes glazing over, especially after their mortgage broker assured them that they had an amazing deal. Yet growing complexity on the borrowers’ side was trivial compared with what was going on at the banks. Mortgages used to be held by the banks that initiated the loans. Now they are sliced into mortgage-backed securities, which include arcane derivative products. Many economists have argued that even if individual consumers suffer from bounded rationality, markets will be set right by specialists who can figure out even the most complex problem. But, as Mr. Greenspan now concedes, even these sophisticated investors got things badly wrong.
2. How did bounded rationality on the part of buyers and lenders contribute to the underlying causes of the housing crisis of 2008, which is still being felt today?
First we have to understand bounded rationality. It is the Concept that