Day 145 in MIT Sloan Fellows Class 2023, Financial Market Dynamics and Human Behavior 6 - "Financial Crisis"

Adaptive Market Theory (AMT) provides a useful framework for understanding the impact of black swan events on financial markets. Black swan events are rare, unpredictable, and have severe consequences, which makes them difficult to anticipate and manage. The phenomenon of asteroids striking Earth and causing a drastic decline in surface temperatures due to innumerable ash clouds is strikingly similar. Consequently, the era of dinosaurs dominating the Earth came to an end due to their failure to adapt, marking the beginning of the age of mammals. It's all about "adaptation". 

Black Monday in 1929

The stock market crash of 1929, also known as Black Tuesday, marked the beginning of the Great Depression. AMT suggests that market participants were overly optimistic and engaged in speculative behavior, leading to an unsustainable market bubble. When the bubble burst, market participants quickly adapted their strategies, selling off assets and becoming more risk-averse. This change in behavior, coupled with other economic factors, led to a prolonged period of economic contraction and high unemployment.

Japanese bubble burst in 1991

The Japanese asset price bubble in the late 1980s was characterized by excessive speculation in real estate and equity markets. In the 1980s, Japan experienced rapid economic growth driven by factors such as strong export performance, low-interest rates, and fiscal expansion. This growth fostered overconfidence among market participants, leading to increased risk-taking behavior and speculative investments in real estate and equity markets. Japanese banks played a significant role in fueling the bubble by providing easy credit to corporations and individuals, encouraging them to invest in real estate and equity markets. In the context of AMT, these financial institutions adapted their strategies to exploit the perceived profit opportunities in the booming markets, disregarding the mounting risks associated with their lending practices.  In response to growing concerns about the sustainability of asset prices, the Bank of Japan (BOJ) tightened its monetary policy by raising interest rates in the late 1980s. This policy shift caused a decline in asset prices, leading to the burst of the bubble in 1991. From an AMT perspective, this overconfidence is an example of bounded rationality, where cognitive biases influence the decision-making process. The AMT framework highlights the role of bounded rationality and herd behavior in inflating the bubble, as well as the adaptive responses that followed, leading to a prolonged period of economic stagnation, known as the "Lost Decade."

Financial Crisis in 2008

The 2008 financial crisis resulted from the collapse of the housing market bubble, fueled by risky mortgage lending practices and financial innovations like mortgage-backed securities. Market participants initially underappreciated the risks associated with these investments, partly due to cognitive biases and overreliance on historical data. When the housing market collapsed, market participants quickly adapted their strategies, leading to a widespread sell-off of assets and a global credit crunch. The AMT framework highlights the importance of understanding the complex, adaptive behaviors of market participants and financial institutions in response to the crisis.

Here is more detail about financial crisis(2008). 

1. Emergence of new financial instruments and strategies: Prior to the 2008 financial crisis, there was a rapid expansion of complex financial instruments, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO). These innovations allowed market participants to diversify and spread risk, which led to increased demand for these assets. AMT suggests that the introduction of these new instruments encouraged market participants to develop novel strategies to exploit potential profit opportunities.
2. Bounded rationality and mispricing of risk: Market participants, including investors, rating agencies, and lenders, failed to fully understand the risks associated with these complex financial instruments. Cognitive biases, such as overconfidence and the belief that housing prices would continue to rise indefinitely, contributed to the mispricing of risk. From the AMT perspective, this is an example of bounded rationality, where market participants' decision-making is influenced by their cognitive limitations and biases.
3. Herd behavior and the housing bubble: As demand for MBS and CDOs increased, lenders began offering riskier mortgages to borrowers with lower credit ratings. This fueled a housing bubble as market participants followed the trend, exhibiting herd behavior. AMT suggests that this adaptive behavior, while profitable in the short term, led to increased risk in the financial system.
4. The tipping point and adaptive responses: The housing market eventually reached a tipping point when housing prices began to decline, and the number of mortgage defaults surged. Market participants quickly adapted their strategies, selling off mortgage-backed securities and other risky assets. Financial institutions faced massive losses, leading to a liquidity crisis and the collapse of several major banks, such as Lehman Brothers.
5. Government intervention and market stabilization: In response to the crisis, governments and central banks around the world implemented various measures, such as bank bailouts, monetary easing, and regulatory reforms. Market participants adapted their strategies accordingly, focusing on risk management and compliance. The AMT framework highlights the importance of these adaptive responses in stabilizing the financial system and preventing a complete market collapse.

There are many hypothesis, but the simple explanation is "too strong correlation destroying the value of senior and junior priority". 

COVID crisis in 2020

The COVID-19 pandemic led to a sudden and unprecedented economic shock, causing significant market volatility and uncertainty. Market participants had to rapidly adapt to new information and changing conditions, leading to sharp declines in asset prices followed by a swift recovery in many markets. The AMT framework emphasizes the importance of understanding the adaptive behavior of market participants in response to such black swan events, as well as the role of government intervention and fiscal policy in stabilizing markets during times of crisis.

Peter D. Hancock

In the classroom, we have an opportunity to hear some talk between Peter D. Hancock, the former President and CEO fo AIG and Prof Andrew Lo. He talked about how he dealt with financial crisis and his perspective about financial scandals such as BTX and SVB. 

He said very impressive thing.

The balance between zoom-in and zoom-out is crucial. Detail is truly important, but if you lose the context and macro perspective, it would be much riskier situation.