Narrator: Listen to part of a lecture in an economics class.
Professor: Good morning class. I hope you had an enjoyable weekend. Now, last week we discussed the housing bubble and credit crisis that nearly destroyed the global economy in 2008. Can anyone recall what the primary cause of that bubble was?
Female Student: Credit that was far too easy to access?
Professor: Right, and it was specifically credit to buy homes that was extended to people who could not afford it. People who had no hope of ever repaying the loans they were taking out. This was driven by speculation on Wall Street—people wanted to invest in fixed income assets that promised a higher return than safer securities, like United States Treasury Bonds. And the investment banks provided them. More and more and more to fill the demand. Unfortunately, everyone was asleep at the wheel and the situation disintegrated to the point where almost no one had any idea just how bad the credit characteristics of these fixed income products had become. Meanwhile, home prices soared, as all this new money was chasing a relatively fixed number of homes on the market. Eventually, the whole thing collapsed.
There are quite a few similarities between this crash and the one before it. Does anyone know what that crash was?
Female Student: The Asian crisis?
Professor: Oh, you mean the financial crisis in Asia, in 1997? Actually… yes, that’s a good one, you can definitely argue that was caused by credit that was too easy. Credit boom, then credit bust, in, uh, Thailand, South Korea, and Indonesia especially. But I was actually thinking of another crash, a little closer to home. Yes?
Male Student: The internet crash?
Professor: Yes. Most people call it the “dot-com crash” or the “dot-com bubble.” But that’s exactly right. This bubble was actually quite short-lived, much like the housing bubble—it took less than 10 years from the beginning of the bubble to the end of the crash. Some bubbles can last for much longer. But what caused it in the first place?
Well, to understand this, you have to understand a bit about psychology. The psychology of investing. See, whenever a new innovation comes along, there is a lot of excitement about it. Innovation means something new; it means business opportunities. For the dot-com crash, it meant new companies sprang up, and these companies needed cash to grow, before they earned any profit. So they needed investors.
Often when this happens, virtually no one has any idea what ideas are going to work. It means that some companies will get overvalued, and some valuable ideas will be ignored. It means that people have no real idea how big the new innovation could be, how big the mature industry will be, and so on. It also means that, if people are making money on these stocks, other investors from other areas are going to see all this money being made in this new area, and they are going to allocate their capital to investing in that new area. Even if they have no idea what’s going on there. A type of “blind mania” takes over.
So—the landscape for investing in this new arena is going to become overcrowded very easily. Many investment dollars will be chasing the relatively few investments that are truly sound and promising. What’s the result? Well, fundamentals get overlooked. Having a solid business plan becomes less important than having a “snappy idea” that you can convince others to buy into. You’re going to get a ton of investments in businesses that are almost certain to fail.
That’s exactly what happened in the late 1990s. And it can take time before people return to their senses—in this case, really, the peak of the “mania” was in roughly 1998 and 1999, and the market for internet companies began sagging in mid-2000. By 2001, the party was over, and trillions of dollars worth of investment capital, at least on paper, was totally wiped out. In fact, by late 2002, the NASDAQ Index, which is heavily technology-weighted, lost nearly 80 percent of its value from its peak only two years earlier. This sounds terrible, and indeed it was, but believe it or not, plenty of crashes in the past have been much, much worse.
So, you have the classic symptoms of a boom-and-crash cycle: a new product or innovation, a large demand to invest in it, a lot of uncertainty about the final outcome—who the winners and losers will be—and a general “mania” or “euphoria” that overcomes the investing public. Once all of these things come together, you have the perfect recipe for a crash. Once the crash starts, this “mania” turns into terror and panic, and everything falls apart. Next week, however, we will see how you can profit from this irrational fear that grows out of the initial, irrational mania.
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What is the main purpose of this talk? |
Gist-purpose. The main discussion of this lecture is market crashes—in particular, the dot-com crash of the early 2000s. |
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| ✗ | A To evaluate the causes of market crashes in the twentieth century |
The lecture is primarily focused on the dot-com crash, which occurred in 2000–2002 (mostly in the twenty-first century). It does not discuss all twentieth-century market crashes. |
| ✓ | B To explore the dot-com crash as a way to understand boom-and-bust cycles in general |
Correct. Roughly half of the lecture is devoted to the specifics of the dot-com crash. Much of the rest explains other crashes or market crashes in general, and how the dot-com crash is a typical example of them. |
| ✗ | C To argue in favor of better regulation to reduce the likelihood or severity of market crashes |
While the professor would likely agree that reducing the severity or frequency of crashes would be a good thing, she does not indicate that regulation could help prevent or diminish them. |
| ✗ | D To predict that boom-and-crash cycles will become less common in the future |
Nothing in the lecture indicates that the professor believes this to be the case. |
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What is the speaker’s opinion about the housing bubble and credit crisis? |
Speaker’s Attitude. This is discussed briefly at the beginning of the lecture. The speaker’s attitude is that no one was paying attention to borrowers’ ability to repay the loans. |
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| ✓ | A Most people were ignoring the ability of borrowers to repay the loans given to them. |
Correct. The key line in the lecture is that “everyone was asleep at the wheel.” That is, the professor believes that people in general (most or all of them) must have been ignoring the ability of borrowers to repay the loans. |
| ✗ | B The investment banks would have preferred that lenders were more selective in choosing homebuyers to lend money to. |
The professor mentions that investment banks provided higher-return investment opportunities, which necessitated more loans being given out. Therefore, it is not clear that the investment banks wanted more selectivity. |
| ✗ | C Investors believed that the loans being given to homebuyers were safer than United States Treasury bonds. |
The professor does indicate that investors wanted higher-return investment options. However, she does not go so far as to say that investors believed such investments were safer than United States Treasury bonds. |
| ✗ | D The increase in home values during the housing bubble was justified. |
The professor believes that the opposite is true. She believes that the increase in home values was unjustified and that the crash was inevitable. |
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According to the professor, when did the dot-com bubble “mania” reach its peak? |
Detail. The professor mentions the timing of three major boom-and-crash cycles: the Asian financial crisis, the dot-com crash, and the housing bubble and credit crisis. |
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| ✗ | A In 2008 |
This is when the housing bubble collapsed after the credit crisis began. |
| ✗ | B In 2001 |
This is when the dot-com crash was occurring. |
| ✓ | C In 1998 and 1999 |
Correct. The professor states that “the peak of the ‘mania’ was in roughly 1998 and 1999.” |
| ✗ | D In 1997 |
According to the professor, this is when the Asian financial crisis happened. |
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Why does the professor mention “other investors from other areas” that began to invest in dot-com companies? |
Organization. This is mentioned to explain some of the factors that contribute to market bubbles, using the dot-com crash as an example. Specifically, the professor mentions these naïve investors to highlight the fact that some were not skilled at investing in this new area. |
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| ✓ | A To highlight the relative inexperience of these investors |
Correct. The lack of experience on the part of these investors—at least in technology companies—contributes to the idea that bad investments were bound to be made. |
| ✗ | B To emphasize that traditional investors in technology were not interested in dot-com companies |
This is not indicated anywhere in the lecture. |
| ✗ | C To argue that the dot-com crash had already begun before these other investors got involved |
If anything, the dot-com crash began after this. The inexperienced new investors were a contributing factor to the crash that came later. |
| ✗ | D To suggest that these investors lacked attractive opportunities in areas they typically invested in |
It is possible that investors experienced at investing in other areas may have been suffering from a lack of interesting opportunities in their typical industries of focus. But nothing in the lecture suggests that this was the case. |
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According to the professor, which of the following factors contributed to the dot-com crash in 2000–2002? Choose 3 answers. |
Detail. Toward the end of the lecture, the professor explains several factors that contributed to the dot-com crash. |
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| ✗ | a A lack of competition among investors in technology businesses |
If anything, the opposite is true. The space was “overcrowded” with investors, which generally leads to increased competition. |
| ✓ | b A high demand to invest in dot-com companies relative to the amount of investment funds being sought |
Correct. The professor strongly implies that there was much more money available for investment into dot-com companies than could be productively used by these companies. This led to bad investments, as is typical in a boom-and-crash cycle. |
| ✓ | c The development of a new product or innovation with great potential |
Correct. This is mentioned directly in the lecture as a contributing factor to the dot-com crash. |
| ✓ | d A great deal of uncertainty about which companies will succeed and which will fail |
Correct. This uncertainty is mentioned directly in the lecture as a contributing factor to the dot-com crash. |
| ✗ | e A loss of interest in pursuing non-technology investments |
The professor never suggests that investors lost interest in investing in non-technology companies. |
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The professor mentions that the investment landscape for a new, promising innovation often becomes overcrowded. What does this fact explain? Choose 2 answers. |
Detail. In the middle of the lecture, the professor mentions that the investing space for a new, promising innovation can become overcrowded. This can lead to too many investments being made, and therefore some poor investments being made. |
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| ✓ | a Why having a solid business plan becomes less important to prospective investors |
Correct. The professor mentions this in describing a primary factor behind the development of market bubbles. Specifically, investment opportunities in the new area are so highly sought that at some point, investors may begin ignoring the fundamentals of a company and are seduced by attractive sales pitches instead. |
| ✗ | b Why a general “mania” or “euphoria” overcomes the investing public |
While this occurrence is true of most boom-and-crash cycles, it is not caused by the investment area becoming overcrowded. If anything, the reverse is true—a general “mania” causes investors to flood into the new area, resulting in overcrowding. |
| ✓ | c Why there will often be many investments made in fundamentally unsound businesses |
Correct. Because the space is overcrowded, there are more investment dollars seeking a company to invest in than there are strong companies seeking investment. As a result, some bad investments usually are made. |
| ✗ | d Why the companies working on developing this innovation typically need cash from investors to grow |
Growing companies typically need cash from investors to grow, but this fact is not explained by the investment space in a market bubble becoming overcrowded. |