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How Psychological Pitfalls Generated the Global Financial Crisis

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How Psychological Pitfalls Generated the Global Financial Crisis
In this article, I present evidence that psychological pitfalls played a crucial role in generating the global financial crisis that began in September 2008. The evidence indicates that specific psychological phenomena—reference point–induced risk seeking, excessive optimism, overconfidence, and categorization—were at work. I am not saying that fundamental factors, such as shifts in housing demand, changes in global net savings rates, and rises in oil prices, were not relevant. They most certainly were relevant. I suggest that specific psychological reactions to these fundamentals, however, rather than the fundamentals themselves, took the global financial system to the brink of collapse.
To what extent did analysts see the crisis coming? In late 2007, four analysts (among others) forecasted that the financial sector would experience severe difficulties. They were
Meredith Whitney, then at Oppenheimer; Dick Bove, then at Punk Ziegel & Company; Michael
Mayo, then at Deutsche Bank; and Charles Peabody at Portales Partners (see Berman 2009). For example, in October 2007, Mayo issued a sell recommendation on Citigroup stock. Two weeks later, Whitney issued a research report on Citigroup stating that its survival would require it to raise $30 billion, either by cutting its dividend or by selling assets. More than any other analyst,
Whitney raised concerns about the risks posed by the subprime mortgage market—and by the attendant threat to overall economic activity.
How timely were analysts in raising the alarm? As it happens, public markets had begun to signal concerns early in 2007. At that time, the VIX was fluctuating in the range 9.5 to 20, having fallen from its 2001-2002 20 to 50 range. On 27 February 2007, an 8.8 percent decline in the Chinese stock market set off a cascade in the global financial markets. In the United States, the S&P 500 Index declined by 3.5 percent, which was unusual during a period of relatively low volatility. Among

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