Are market downturns & crashes really driven by fear?

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Neoseo1300
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Are market downturns & crashes really driven by fear?

Post by Neoseo1300 » Fri Jun 07, 2019 9:02 pm

We often hear on TV or read in the news that fear is the main driver of market crashes but I'm wondering to what extent this is true. It seems so counter-intuitive to me that people would sell massively when stocks are losing value, especially when history has shown that markets always bounce back at some point in time. Second, it seems that most of the trading volume in the market is generated by institutional investors, who are normally less prone to irrational fear than the average Joe, so markets as a whole should be less impacted by the potential fear of individuals.

Therefore could it be that market crashes are mainly driven by other things than fear? Maybe leveraged positions from institutional investors that lead to unsustainable positions (because of margin calls, etc.) and brutal unwinding of positions (on top of mechanical unwinding due for exemple to credit rating changes, etc) could explain trends better? I remember talking to a trader from a big US bank recently and he was telling that multiple times before and during previous crashes, colleagues of him were forced to exit a position, not because they got scared, but because they financially had to; that, obviously, didn't play in favor of market stability.

I dont have any sources, or data to support my thinking so if anyone has links that discuss that subject, i'll be more than happy to have a look! Happy to hear your thoughts too!

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Re: Are market downturns & crashes really driven by fear?

Post by Tycoon » Fri Jun 07, 2019 9:20 pm

I don't know the answer to your question. I do know that fear is a powerful motivator. Judging from the many posts over the last three years about impending market crashes and the downfall of civilization, I'd posit that fear plays a significant role in market downturns.
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Re: Are market downturns & crashes really driven by fear?

Post by MotoTrojan » Fri Jun 07, 2019 9:25 pm

Japan never bounced back. US market history isn’t a guarantee.

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Re: Are market downturns & crashes really driven by fear?

Post by KlangFool » Fri Jun 07, 2019 9:31 pm

OP,

Which kind of market downturn & crashes that you are referring to?

For example, with 10+ years of the bull market, many people are 100% stock with small to zero emergency fund. If we hit a recession and many of the same people will be unemployed. They will have to sell stock in order to feed their families. And, in a recession, there will be more sellers than buyers. So, the stock market will go down.

So, it is not necessarily driven by FEAR. It could be many people overly estimated their capabilities to handle the risk.

It's only when the tide goes out that you learn who has been swimming naked.
- Warren Buffett

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Neoseo1300
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Re: Are market downturns & crashes really driven by fear?

Post by Neoseo1300 » Fri Jun 07, 2019 9:42 pm

MotoTrojan wrote:
Fri Jun 07, 2019 9:25 pm
Japan never bounced back. US market history isn’t a guarantee.
I fully agree, but I doubt this is the reason why people have been selling in most recent crashes (2000, 2008).
KlangFool wrote:
Fri Jun 07, 2019 9:31 pm
OP,

Which kind of market downturn & crashes that you are referring to?

For example, with 10+ years of the bull market, many people are 100% stock with small to zero emergency fund. If we hit a recession and many of the same people will be unemployed. They will have to sell stock in order to feed their families. And, in a recession, there will be more sellers than buyers. So, the stock market will go down.

So, it is not necessarily driven by FEAR. It could be many people overly estimated their capabilities to handle the risk.

It's only when the tide goes out that you learn who has been swimming naked.
- Warren Buffett

KlangFool
Agreed. But it goes back to the point made about institutional investors. People may be swimming naked, which forces them to sell at the worst possible time. Not that they were afraid but they had too (which makes total sense).

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Re: Are market downturns & crashes really driven by fear?

Post by KlangFool » Fri Jun 07, 2019 9:45 pm

Neoseo1300 wrote:
Fri Jun 07, 2019 9:42 pm


Agreed. But it goes back to the point made about institutional investors. People may be swimming naked, which forces them to sell at the worst possible time. Not that they were afraid but they had too (which makes total sense).
Neoseo1300,

Why do you think that institutional investors cannot face the same kind of problem? Aka, they are overly leveraged?

KlangFool

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Re: Are market downturns & crashes really driven by fear?

Post by Wakefield1 » Fri Jun 07, 2019 9:49 pm

If I am correct it doesn't require much selling or increase in selling to send the markets down,all it takes is for buying to dry up some.
And current prices are driven by current buying vs. selling,cumulative flows of money that have occurred previously into/out of the markets have little effect on current prices -at least as far as I understand

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Re: Are market downturns & crashes really driven by fear?

Post by venkman » Fri Jun 07, 2019 9:50 pm

Neoseo1300 wrote:
Fri Jun 07, 2019 9:02 pm
Second, it seems that most of the trading volume in the market is generated by institutional investors, who are normally less prone to irrational fear than the average Joe, so markets as a whole should be less impacted by the potential fear of individuals.
For active managers, career risk might be more important to their decision-making than market risk.

Say you're an active manager who holds a significant position in stock x, and stock x starts going down. A lot of other funds seem to be selling it off. You think it's a solid company, and this is only a temporary drop, so you're inclined to hold, but...
  • If you hold it and it rebounds quickly, you look like a genius compared to everybody else. CNBC might do a story on you.
  • If you hold it and it DOESN'T rebound, you look like an idiot compared to everybody else. Your fund underperforms most others, and you might well get fired.
  • If you sell when everyone else is selling, it doesn't matter what the stock does. No one is going to fault you for doing what all the other "professionals" were doing, regardless of whether the decision turned out to be good or bad.
From the point of view of a fund manager, the safest move is to do what everybody else is doing. Your potential gains from going against the crowd are not worth the potential risks of going against the crowd, even if you think the crowd is wrong.

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Re: Are market downturns & crashes really driven by fear?

Post by nedsaid » Fri Jun 07, 2019 9:50 pm

Market downturns and crashes are most often driven by fear. Often these events occur with a big news event. But weird stuff happens in the markets for which even the professionals can't always explain, I attribute this to a big hedge fund unwinding a bet that didn't work out. Seeing that leverage is involved, the effects of hedge funds unwinding losing bets are magnified. So my reaction to a sudden and unexplained movement in the markets is that the hedge funds are doing something big. In an unexpected down turn, like the 1,000 point plunge in the Dow, I wonder who the idiot was that screwed this up.
A fool and his money are good for business.

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Re: Are market downturns & crashes really driven by fear?

Post by AlohaJoe » Fri Jun 07, 2019 10:35 pm

Neoseo1300 wrote:
Fri Jun 07, 2019 9:02 pm
I dont have any sources, or data to support my thinking so if anyone has links that discuss that subject, i'll be more than happy to have a look!
I don't think it is about fear per se but about overreaction.

The most compelling (to me) explanation comes from Nicola Gennaioli & Andrei Schleifer and their "diagnostic expectations" model. They published a book on it in 2018, A Crisis of Beliefs: Investor Psychology and Financial Fragility but I don't recommend it. It is tough slogging and largely about trying to provide rigorous (i.e. in a mathematical & academic sense) underpinnings, which probably isn't something 99% of readers actually care about. (That said, it is nice to know it isn't just a hand-wavy "sounds good to me" model.)

Their basic model is that market participants have "diagnostic expectations" about the future. Those expectations are "extrapolative" rather than rational. That is, they mostly assume the recent past ("recency bias") will continue on in a mostly unchanged linear way. The most remarkable exhibit of this is a report from the Federal Reserve's forecasting staff on July 30, 2008 -- just six weeks before Lehman -- when their "severe financial stress" scenario forecast 6.7% peak unemployment (in reality, over 10%) and 0.5% real GDP growth in 2009 (in reality, -2.7%).

The expectations are "diagnostic" because they tend to rely on "representativeness bias". That is, beliefs contain a "kernel of truth" but our beliefs exaggerate true patterns in the data. The canonical example is when we learn that someone we haven't met is Irish most people will assume they have red hair, even though red hair is rare among the Irish. (It is just less rare than among other peoples.) There is a "kernel of truth" about red hair & the Irish but our beliefs cause us to overreact and warp the underlying actual pattern.

When described in simple terms their model doesn't sound that novel. Their real work has been taking it from a layperson's description to making it something that real economists can grapple with.

Their model accounts for leverage, credit cycles, and more. They provide a compelling explanation for the details of the 2008 crash. One of their main points is that prices peaked in mid-2006 and had been declining ever since. Defaults doubled in 2007. New Century filed for bankruptcy in April 2007. But it wasn't until September 2008 (the Lehman default) that things "crashed".
Why was Lehman so pivotal? Surely there is nothing special about Lehman per se. We would have seen the same market distress if it were AIG or Merrill Lynch. So, what was the real news in the Lehman bankruptcy that caused such a sharp market reaction that surprised both investors and policymakers? What did the markets and policymakers learn that they did not know before? Certainly the news was not that Lehman was in deep trouble, since this was known for months. The policymakers in fact were publicly trying to convince Lehman to merge with another company for close to half a year. Nor was it news that the housing bubble was deflating, since by September this was very old news as well. nor was it news that financial institutions were losing hundreds of billions of dollars, since that too was widely understood at the time.
Their answer is that the Lehman crash spoke to both recency bias and representativeness bias, which caused market participants to update their diagnostic expectations.

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Re: Are market downturns & crashes really driven by fear?

Post by heyyou » Sat Jun 08, 2019 12:18 am

Consider the dollar volume of daily trading versus the combined values of every market listed business, to see how a minuscule amount of crazed trading can change the stock prices of the entire stock market. My point is that both booms and busts are driven by irrational perceptions of stock prices. I will leave it to others for them to discern which words best describe the emotions of the sellers in those trades.

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Re: Are market downturns & crashes really driven by fear?

Post by chem6022 » Sat Jun 08, 2019 12:42 am

1) A good crash usually starts with a new reality or realization by a large number of investors. Something fundamentally changes their outlook, like AlohaJoe refers to in the financial crisis.
2) The effect is amplified by "aware" investors. These people knew the game was afoot, but were still willing to play up until now. For example, they saw the bubble happening and knew we were playing musical chairs with valuations, but found the profits worth the wait until now that the music stopped. Their stop losses trigger and send the markets lower. Active fund managers unload to protect their clients.
3) Now it's dropped enough that some others are more desperate and fearful than they anticipated, leading to more waves of selling.

So I think overall the real fear effect is just the icing on the cake. The point of maximal fear is much closer to the bottom, in the same way the point of maximal optimism was much closer to the top.

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Re: Are market downturns & crashes really driven by fear?

Post by alpine_boglehead » Sat Jun 08, 2019 1:04 am

KlangFool wrote:
Fri Jun 07, 2019 9:31 pm
And, in a recession, there will be more sellers than buyers. So, the stock market will go down.
John C. Bogle wrote: Really?! The simple, self-evident fact is that when "everyone" is buying, someone else is selling, dollar for dollar. And when "everyone" is selling, someone else is buying. This is the enternal reality of the financial markets.
From Jack's Bogleheads conference keynote, linked in this thread viewtopic.php?f=10&t=280653&newpost=4536965

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Re: Are market downturns & crashes really driven by fear?

Post by HEDGEFUNDIE » Sat Jun 08, 2019 4:03 am

AlohaJoe wrote:
Fri Jun 07, 2019 10:35 pm
Neoseo1300 wrote:
Fri Jun 07, 2019 9:02 pm
I dont have any sources, or data to support my thinking so if anyone has links that discuss that subject, i'll be more than happy to have a look!
I don't think it is about fear per se but about overreaction.

The most compelling (to me) explanation comes from Nicola Gennaioli & Andrei Schleifer and their "diagnostic expectations" model. They published a book on it in 2018, A Crisis of Beliefs: Investor Psychology and Financial Fragility but I don't recommend it. It is tough slogging and largely about trying to provide rigorous (i.e. in a mathematical & academic sense) underpinnings, which probably isn't something 99% of readers actually care about. (That said, it is nice to know it isn't just a hand-wavy "sounds good to me" model.)

Their basic model is that market participants have "diagnostic expectations" about the future. Those expectations are "extrapolative" rather than rational. That is, they mostly assume the recent past ("recency bias") will continue on in a mostly unchanged linear way. The most remarkable exhibit of this is a report from the Federal Reserve's forecasting staff on July 30, 2008 -- just six weeks before Lehman -- when their "severe financial stress" scenario forecast 6.7% peak unemployment (in reality, over 10%) and 0.5% real GDP growth in 2009 (in reality, -2.7%).

The expectations are "diagnostic" because they tend to rely on "representativeness bias". That is, beliefs contain a "kernel of truth" but our beliefs exaggerate true patterns in the data. The canonical example is when we learn that someone we haven't met is Irish most people will assume they have red hair, even though red hair is rare among the Irish. (It is just less rare than among other peoples.) There is a "kernel of truth" about red hair & the Irish but our beliefs cause us to overreact and warp the underlying actual pattern.

When described in simple terms their model doesn't sound that novel. Their real work has been taking it from a layperson's description to making it something that real economists can grapple with.

Their model accounts for leverage, credit cycles, and more. They provide a compelling explanation for the details of the 2008 crash. One of their main points is that prices peaked in mid-2006 and had been declining ever since. Defaults doubled in 2007. New Century filed for bankruptcy in April 2007. But it wasn't until September 2008 (the Lehman default) that things "crashed".
Why was Lehman so pivotal? Surely there is nothing special about Lehman per se. We would have seen the same market distress if it were AIG or Merrill Lynch. So, what was the real news in the Lehman bankruptcy that caused such a sharp market reaction that surprised both investors and policymakers? What did the markets and policymakers learn that they did not know before? Certainly the news was not that Lehman was in deep trouble, since this was known for months. The policymakers in fact were publicly trying to convince Lehman to merge with another company for close to half a year. Nor was it news that the housing bubble was deflating, since by September this was very old news as well. nor was it news that financial institutions were losing hundreds of billions of dollars, since that too was widely understood at the time.
Their answer is that the Lehman crash spoke to both recency bias and representativeness bias, which caused market participants to update their diagnostic expectations.
Great explanation and rationale for the momentum factor.

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Re: Are market downturns & crashes really driven by fear?

Post by Rus In Urbe » Sat Jun 08, 2019 6:11 am

+1
Great explanation and rationale for the momentum factor.
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Re: Are market downturns & crashes really driven by fear?

Post by raoul » Sat Jun 08, 2019 6:18 am

Perusing the replies regarding the 'fear' factor I can only assume most of you have never heard of algorithm trading programs which influence stock movements in greater scope than individual investors. These programs have specific markers placed in their makeup which can trigger selling in a nano second. Once they signal downturns the rest is history since investors for the most part follow the mob mentality.

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Re: Are market downturns & crashes really driven by fear?

Post by SovereignInvestor » Sat Jun 08, 2019 6:20 am

MotoTrojan wrote:
Fri Jun 07, 2019 9:25 pm
Japan never bounced back. US market history isn’t a guarantee.
Japan Nikkei traded at over 50x forward earnings in 1990, right as the point in 1990 when anyone lookong at Japanese birth statistics and demographics would have saw their work force population dropping off a cliff in 2000 (down about 1.5% annually since then). So basically an investor in 1990 should have expected at least 60% PE contraction to get to longer term norm PE, plus struggle to have any actual growth with population set to decline. If population declines 1.5% annually..even if productivity is up 2% which is good, the real GDP only rises 0.5%. Also instead of buying the Nikkei Japanese investors could have gobble up government bonds with 6-7% yields in 1990.

US investors are buying stocks at 16x forward earnings which is actually slightly below the 25 year average and the work force in US is set to grow about 0.5% annually for next 3 decades which likely avoids the no growth scenario ( add on 1% productivity growth and hard for real GDP to stagnate). The safe alternative is 10Y Treasurys yielding barely 2.0%.

There are many reasons to be concerned and risks to the US investor but the factors that made the Nikkei tank for 30 years are totally absent in the US now.

https://seekingalpha.com/article/4234665?source

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Re: Are market downturns & crashes really driven by fear?

Post by Fallible » Sat Jun 08, 2019 7:53 am

The powerful emotion of fear (and greed) plays out in many ways in the markets, as in life. It's sometimes difficult to know exactly how it does that, at what point, or how much. But since investors must always deal with risk and uncertainty (and their own tendencies to loss aversion), fear is probably always there in some form or to some extent, and that would include events you've referred to leading up to market downturns and crashes.

I think understanding fear will help to identify its role in our decisions and investing behavior, and there are many good books and blogs on that, in particular those on Behavioral Finance by Richard Thaler, Meir Statman, Hersh Shefrin, etc., and on neuroscience. One excellent book that specifically addresses fear (and greed) is Your Money & Your Brain (chapter on "Fear") by WSJ columnist Jason Zweig.
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Re: Are market downturns & crashes really driven by fear?

Post by Dottie57 » Sat Jun 08, 2019 7:59 am

Wakefield1 wrote:
Fri Jun 07, 2019 9:49 pm
If I am correct it doesn't require much selling or increase in selling to send the markets down,all it takes is for buying to dry up some.
And current prices are driven by current buying vs. selling,cumulative flows of money that have occurred previously into/out of the markets have little effect on current prices -at least as far as I understand
Louis Rukeyser used to call a “sell off of stock” a flight to safety. Just like sparrows who are spooked, fly to to a bush for cover.

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Re: Are market downturns & crashes really driven by fear?

Post by Sandtrap » Sat Jun 08, 2019 8:03 am

Dottie57 wrote:
Sat Jun 08, 2019 7:59 am
Wakefield1 wrote:
Fri Jun 07, 2019 9:49 pm
If I am correct it doesn't require much selling or increase in selling to send the markets down,all it takes is for buying to dry up some.
And current prices are driven by current buying vs. selling,cumulative flows of money that have occurred previously into/out of the markets have little effect on current prices -at least as far as I understand
Louis Rukeyser used to call a “sell off of stock” a flight to safety. Just like sparrows who are spooked, fly to to a bush for cover.
+1
Great metaphor.
Humans can be skittish when it comes to loss of finances. :shock:
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Re: Are market downturns & crashes really driven by fear?

Post by Dandy » Sat Jun 08, 2019 8:06 am

I'm sure there are many causes to downturns and crashes. I think fear acts like gasoline on a fire -- it makes bad things even worse.

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Re: Are market downturns & crashes really driven by fear?

Post by nisiprius » Sat Jun 08, 2019 9:14 pm

During the Great Depression, it was often suggested that the cause was fear and pessimism, and that the Depression could be ended by positive thinking.

Radio stations began a formal campaign of playing only optimistic songs, which is why there are so many cheerful songs from that era. (A notable exception, Gloomy Sunday, was accused of causing people to commit suicide, and an attempt was made to ban it).

People put up billboards saying "Wasn't the Depression terrible?" with the idea that maybe you couldn't outright deny it, but if you could just get people to think about it in the past tense, it would soon be in the past.

A number of cities held huge parades, called "funeral processions for Old Man Depression."

Lodges and fraternal organizations fined members for mentioning the depression.

I don't think it worked.
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Re: Are market downturns & crashes really driven by fear?

Post by 272 Sheep » Sat Jun 08, 2019 10:29 pm

Its easy to be brave when the sun is shining. But when after losing a large portion of your money that you worked hard for,
will you stay brave?

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Re: Are market downturns & crashes really driven by fear?

Post by Valuethinker » Sun Jun 09, 2019 9:29 am

AlohaJoe wrote:
Fri Jun 07, 2019 10:35 pm
Neoseo1300 wrote:
Fri Jun 07, 2019 9:02 pm
I dont have any sources, or data to support my thinking so if anyone has links that discuss that subject, i'll be more than happy to have a look!
I don't think it is about fear per se but about overreaction.

The most compelling (to me) explanation comes from Nicola Gennaioli & Andrei Schleifer and their "diagnostic expectations" model. They published a book on it in 2018, A Crisis of Beliefs: Investor Psychology and Financial Fragility but I don't recommend it. It is tough slogging and largely about trying to provide rigorous (i.e. in a mathematical & academic sense) underpinnings, which probably isn't something 99% of readers actually care about. (That said, it is nice to know it isn't just a hand-wavy "sounds good to me" model.)

Their basic model is that market participants have "diagnostic expectations" about the future. Those expectations are "extrapolative" rather than rational. That is, they mostly assume the recent past ("recency bias") will continue on in a mostly unchanged linear way. The most remarkable exhibit of this is a report from the Federal Reserve's forecasting staff on July 30, 2008 -- just six weeks before Lehman -- when their "severe financial stress" scenario forecast 6.7% peak unemployment (in reality, over 10%) and 0.5% real GDP growth in 2009 (in reality, -2.7%).

The expectations are "diagnostic" because they tend to rely on "representativeness bias". That is, beliefs contain a "kernel of truth" but our beliefs exaggerate true patterns in the data. The canonical example is when we learn that someone we haven't met is Irish most people will assume they have red hair, even though red hair is rare among the Irish. (It is just less rare than among other peoples.) There is a "kernel of truth" about red hair & the Irish but our beliefs cause us to overreact and warp the underlying actual pattern.

When described in simple terms their model doesn't sound that novel. Their real work has been taking it from a layperson's description to making it something that real economists can grapple with.

Their model accounts for leverage, credit cycles, and more. They provide a compelling explanation for the details of the 2008 crash. One of their main points is that prices peaked in mid-2006 and had been declining ever since. Defaults doubled in 2007. New Century filed for bankruptcy in April 2007. But it wasn't until September 2008 (the Lehman default) that things "crashed".
Why was Lehman so pivotal? Surely there is nothing special about Lehman per se. We would have seen the same market distress if it were AIG or Merrill Lynch. So, what was the real news in the Lehman bankruptcy that caused such a sharp market reaction that surprised both investors and policymakers? What did the markets and policymakers learn that they did not know before? Certainly the news was not that Lehman was in deep trouble, since this was known for months. The policymakers in fact were publicly trying to convince Lehman to merge with another company for close to half a year. Nor was it news that the housing bubble was deflating, since by September this was very old news as well. nor was it news that financial institutions were losing hundreds of billions of dollars, since that too was widely understood at the time.
Their answer is that the Lehman crash spoke to both recency bias and representativeness bias, which caused market participants to update their diagnostic expectations.
Thank you that was very informative and helpful.

3 things about Lehman:

- it was the most connected institution to fail at that point. Bank of England mapping showed how highly connected it was, more than any other financial institution of its (modest) size.

Thus greater fear of counterparty loss and contagion. Its failure triggered an almighty scramble to get hikd if and liquidate collateral into a falling market.

The Repo market froze and that killed the interbank lending market. And that left hundreds of financial market participants exposed.

- it signalled that the authorities would not backstop financial institutions. It appears that the US authorities imagined a kind of Continental Bank windup. Whereas in actual fact under UK law a full and immediate insolvency took place. There is that revealing interview with a top US insolvency practitioner in "Inside Job" documentary where he explains US Treasury officials just did not understand Englush bankruptcy practice. And half of Lehman Brothers was run from London.

That was important new information to investors.

There was this obsession with Moral Hazard that led US regulators to underestimate that this was the "Credit Anstalt Moment" (1931) or the Grant Cutler Moment (1873).

- falls in prices force margin calls and deleveraging so a sudden collapse liquidity combined with forced sellers means lower prices and more forced sellers.

This is like 1929 or 1987. Lower prices mean lower prices.

Again that is new information to investors. That prices are likely to gap down sharply and thus it is rational to try to get out first.

The result is "fire in a crowded nightclub". We jam the exits, trying to sell.

Until the British and Ameruxan governments announced they would, in effect, rescue any failing financial institutions, money markets just ceased to function as the Shadow Banking system imploded.

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