Human Behavior and Financial Crises
Thursday, July 1st, 2010The building of the housing market bubble and then the bursting of this bubble, and the financial crisis that blew up in 2008, exposed significant failures in decision-making on the part of both the private and public sectors. The fact is that there has been a series of financial crises since the deregulation of the financial markets started in the 1980’s, indicating that while the current crisis is far worse than what has been observed in recent years it was part of a pattern. Starting with the saving and loan crisis of the late 1980’s, to the bursting of the NASDAQ stock market bubble in the late 1990’s to 2000, and the more recent crisis among others, economists and behavior scientist have learned a lot about how these events happen. These lessons explain why those countries with tighter regulations on their financial markets and banking system (like Canada) did not experience a significant recession and financial crisis.
What has historically led to financial crises? In many ways the answer revolves around perceptions of greed and fear. Specifically, many have wrote that too much greed and too little fear leads to financial crises, and the too much fear and too little greed sustains financial crises. What precipitates financial crises and feeds into the greed is the poor evaluation of risk leading to irrational evaluations of risk versus reward. This poor evaluation of risk could be due to greed clouding the perception of reality or due to not investing the time necessary to evaluate the risk associated with an investment. An example would be those who bought complex financial derivatives that ultimately failed because they did not unravel and expose the risk exposure of the investments whose value supported the price of the financial derivatives. Specifically, the poor evaluation of risk leads to poor credit evaluation. Often, as we have seen, the probability of extreme events is higher than anticipated or accepted by investors, but repeatedly investors have contributed to the development of investment bubbles and then crises. In addition, Wall Street firms and other banks did not hold enough strong secondary reserves to secure capital adequacy.
A contributing factor to the most recent crisis is that the pressure to profit in the short-run trumped long-term perspectives by many individuals and firms. An example is related to Moody’s and Standard and Poors. These firms were paid by the same firms whose credit products they were rating, a conflict of interest. Moody’s and Standard and Poors did not downgrade the debt issued by firms like AIG, Fannie Mae, and other firms who assumed additional debt as they issued the credit products Moody’s and Standard and Poors were rating. Moody’s and Standard and Poors did not expose financial risk; instead they understated risk. Paul Krugman in the New York Times recently noted that of the AAA – rated subprime-mortgage-backed-securities issued in 2006, 93 percent have been downgraded to junk status. Risk was significantly under-estimated and as a result interest rates were too low. Similar irresponsible and risky behavior was evident in the decisions made by Merrill Lynch, AIG, and Lehman Brothers, and many others.
The behavior of all of those who precipitated the financial crisis now appears to have been irrational and short-sighted. This raises a question; do people behave rationally? Current research has answers for this question. For example, we know that people are more likely to see data that supports their preconceived points of view rather than data that contradicts their preconceived points of view. In addition, people overvalue current events when developing expectations. Another fact is that people prefer a single explanation for events rather than a nuanced explanation for facts. This is an interesting point because all too often the popular media exploits this fact by presenting overly simplified answers to difficult and divisive questions, and they also avoid nuance to further an agenda whether be political or other goal. Complicating this further, we overvalue our talents when decisions prove to be profitable rather than considering the impact of factors completely outside of our control.
Businesses and individuals will often combat these issues by establishing complex analytical models, risk analysis strategies, and hedging programs. The problem can be that complexity will outstrip our ability to understand the process we are dealing with. The complexity of financial modeling and synthetic securities has now been shown to be one of the sources of the financial crisis itself. We know that it is hard to connect the impact of a series of potential errors. These points, combined with the fact that people can become too acclimated to risk help explain how a series of financial crises can occur, especially since it is easy to have too much faith in risk management systems. Complex governing structures are also not necessarily the solution for mitigating complex systems that increase risk because complexity can negate judgment and makes assessment difficult. Furthermore, it is all too easy for group-think to develop among individuals in the same field of work. These points suggest that checks and balances in the investment decision-making by firms that encourage and reward the free input of ideas and points of view would enhance the risk management process.
Many economists also got things wrong in the run-up to the financial crises and recession. One of a group of prominent exceptions is Robert Shiller who identified the housing bubble and warned about its consequences. Another was Paul Krugman. There were many others, but most did not express real concern. Many economists believed that markets always tended to be stable (rational expectations). This led to support for the efficient market hypothesis - the idea that financial markets price assets at exactly equal to a value supported by all known fundamentals. The problem is this undervalues the role of bubbles or destructive speculation. Some economists forgot the lessons learned from the Great Depression and undervalued lessons learned from more recent financial crises. In effect, macroeconomists have been separated into two mutually exclusive camps – those who believe markets are inherently rational (and as a result economic growth depends on the advent of new technology combined with changes in the supply of labor) versus those who were Keynesian economists who sought to combine the possibility of demand-side reasons for recessions with models assuming rational expectations. This resulted in something close to group think that discounted the possibility of bubbles and irrational behavior. The argument that bubbles don’t happen gained prominence. For example, the influential economist, Eugene Fama argued, “housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.” The Federal Reserve, including Alan Greenspan and Ben Bernanke, also discounted the possibility of a housing bubble
Another important contributor to these misperceptions was the over-reliance on elegant mathematic models and not accounting for the behavioral aspects of decision-masking that can lead to irrational or unpredictable decision-making. This has led to greater acceptance of new movements in economics, including behavioral economics and finance. We know that real-world investors are subject to herd behavior, speculative excess and irrational exuberance. Investors who seek to base their investment decisions based on economic and financial fundaments lack complete credible information, and have limited collateral leading to following the herd. People tend to over-value small losses and under-value small gains and are too likely to extrapolate from small samples. A severe decline in asset prices that is not supported by fundaments will lead under-capitalized investors to quickly see their capital be depleted forcing even the “smart” money to sell and feed a downward spiral
Interesting, the great American writer Philip Roth captured the above points in the following quotes, “Fear tends to manifest itself much more quickly than greed, so volatile markets tend to be on the downside. In up markets, volatility tends to gradually decline “and “Obviously the facts are never just coming at you but are incorporated by an imagination that is formed by your previous experience. Memories of the past are not memories of facts but memories of your imaginings of the facts.”
Paul Palley
