Why Didn’t Subprime Investors Demand (Much More of) a Lemons Premium?

Abstract:     
The subprime crisis would never have occurred had investors not been such enthusiastic consumers of subprime securities. The investors now say, somewhat self-servingly (but probably correctly), that they did not understand the securities - securities for which they were willing to pay very high prices. This essay seeks to explain investors’ readiness to pay premium prices for these novel and complex instruments.

The most satisfactory explanation lies in the incentives for herding among agents who made investment decisions for others. Investors (and markets) compare investment managers to other investment managers. A manager’s best strategy, therefore, may be to do what her peers do regardless of whether the manager believes her peers are a reliable source of information about the quality of the investment decision. Standard psychological forces including over-optimism and confirmation bias also help explain how this trajectory progresses and continues. Policy responses should take investor herding into account.

Number of Pages in PDF File: 17

Keywords: herding, lemons, subprime securities, investors

JEL Classification: D81, D82, G24, K22

Accepted Paper Series