Reinhard Selten, 78: I would like to remind people that the financial market crisis had its roots in a bubble in the American real estate market. The problem is not just a question of the financial markets, but is generally tied to markets for assets. These markets are far less stable than other markets for goods. False expectations often arise in these markets.
Many expected the rise in real estate prices in America to continue indefinitely. People believed that because of rising affluence, population growth and the scarcity of land, house prices could only increase. This expectation has since been thoroughly dashed.
Because of the lack of stability in the markets for assets, regulation of the financial market is important. We must ensure that speculative investments are secured by sufficient equity. This also applies to mortgages. In the United States, mortgages were approved for up to 110 percent of market value. In addition, these mortgages came with variable interest rates and a limitation of the mortgage holder's liability with respect to the value of the house.
When the US central bank, the Federal Reserve Bank, constantly increased the prime rates at frequent intervals by 0.25 percent at a time, mortgage interest rates eventually doubled and many mortgage borrowers chose to turn over their keys to the bank and rent someplace else for less. This, of course, led to a decline in real estate prices, causing difficulties for banks.
In the last 10 years, a revolution has taken place in the banking industry. Banks sold more and more of a new type of security in which hundreds of mortgage receivables with roughly the same risk were combined into a single security. The loan securitizations, known as subprimes, were bundles of especially high-risk loans. It was not expected that borrowers would default on many of these mortgages at the same time. For this reason German banks sold large numbers of the securities, which were highly profitable, as investments. The rating agencies gave these securities AAA ratings.
Apparently the market does not value new types of complex securities correctly. For this reason, it is necessary to establish rules for the registration of new types of securities. Securities, not unlike food, should be given risk-related labels.
The prevailing portrayal of economic behavior in economic theory is based on very strong assumptions of rationality, which are not fulfilled in reality. If economic subjects were completely rational, as defined in economic theory, the markets could be left to their own devices without the risk of development of serious and long-lasting imbalances.
But such optimism about stability is unjustified. Economic theory must progress to form a more realistic picture of human behavior. A lot of empirical and experimental research is needed for this purpose.
And the rules of the financial markets must not just affect banks, but also other institutions that are active in financial markets, like hedge funds. Under no circumstances should it be possible for banks to spin off highly speculative deals into special purpose entities, as was the case with a few state-owned banks in Germany. These special purpose entities are not subject to the strict rules that are imposed on banks.
We must take steps to ensure that proposed regulations are, on the one hand, as straightforward as possible and, on the other hand, cannot be circumvented. Of course, detailed institutional and legal knowledge is necessary to construct such rules. As is so often the case, the devil is in the details.