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How Optimism Got Us in Trouble in Financial Markets: Or Why Smart People do Stupid Things

There's a risk when there is too much optimism.

In a previous post- Taking the Blinders Off: Knowing What You Should Really Worry About-- I suggested that there are many things that we should worry about but that we don't seem to bother to worry about. These include risky habits such as smoking, drinking, overeating, spending too much, risky sex, and driving dangerously. People generally don't worry about these things-if we define worry as recurrent, unwanted negative thoughts about the future. The same processes that lead us to avoid everyday real risks have contributed to the development of an overly risky financial market and credit crisis. The financial crisis is due to building a house of cards and then acting like we are surprised when it collapses. There's a risk when there is too much optimism.

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But what has led us to build a house of cards?

And, why was the house of cards built by highly intelligent people---many with MBAs? How can smart people be so stupid?

Memory Lane and a House of Cards

Let's take a short trip down memory lane to understand how things developed.

Congress, in its infinite wisdom, decided years ago (1999) it was politically advantageous to assure that people without sufficient means should be able to get mortgages with very little down-payment and at subprime interest rates. ‘'Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ‘'Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.'' Thanks for Fannie Mae advocates, lots of people who couldn't afford payments could incur substantial debt.

This was immensely popular with people who could now own their own homes---or, at least, think they actually owned their own homes. Let's say that they bought a house for $250,000 and put down $20,000---they still owed the bank $230,000. So, they actually didn't own the house -the bank had most of the claim on the house. But they lived in the house and hoped that the property values would go up. And they hoped that their incomes would go up to cover the ballooning adjustable rate mortgages. As long as everything went fine, everyone was happy. In fact, millions of people did quite well. For a while. Optimism ruled.

Many of these applicants for mortgages were known in the business as NINJAs. They had No Interest Loans and No Jobs. NINJAs. Like NINJAs they felt proud and invulnerable. That is, until their property values fell, their mortgage payments ballooned, and they realized they had no real equity in their homes. Until the sorry day that they had to foreclose.

Despite warnings over the last nine years---from intelligent people from both sides of the political spectrum--- subprimes, predatory lending, and other risky practices continued. Indeed, the very people that subprimes and low down-payment standards were aimed for were the biggest victims. This is why some members of Congress, representing working class people, eventually warned of "predatory lending practices". But by then the party was too big to stop. See NY Times article on how this all developed.

Is Everyone Happy?

But before the bottom fell out, there were a lot of happy people going to the bank ---and leaving the bank with a lot of money. The bank officer who sold the mortgage got points and got a raise. The borrower got a house to live in-one he could not afford-but he was optimistic anyway. The bank then passed the buck (the mortgage) to Washington Mutual---and the bank made money up front--- and lent that out. And Washington Mutual made a profit on the mortgages, as long as people were paying. They were smiling. Everyone got a quick fix. And the house of cards got bigger and bigger.

Everyone was happy. Washington Mutual and the geniuses on Wall Street divided up the mortgages as "property" to secure other instruments of investment-called mortgage backed securities (MBS--- and I would like to emphasize "BS"). More BS for your mortgage lenders and borrowers.

They were all passing the buck-until the rest of us ended up holding the bag.

These were sold in the general market and became leverage for other loans and investments that were sold. Some of your investments were in those securities and-- for a while-you and I were happy. The whole world was smiling. We sang in perfect harmony.

Investment banks and hedge funds used these and other instruments of investment as a basis to leverage other investments. If I have a thousand dollars then I can borrow ten thousand dollars. I feel rich. I feel good right now. And the market was going up. I am cheering. The party seems to go on forever.

Foreign investors didn't want to be left out of the American Dream. They jumped in. They also want to feel good. And, don't they deserve a piece of the action? Aren't they human, just like the rest of us? How can anyone believe the warnings about Fannie and Freddy when everyone is getting rich and the price of real estate keeps going up?

Example: a patient tells me that real estate is a safe investment. "It always goes up" There is no law of gravity. He is going to buy an apartment that stretches his budget-with a payment plan that he doesn't pay any principle for ten years. He hopes that his bonus will help him afford this and he feels absolutely certain that his apartment will increase in value. It's a sure thing.

Sure things are often bad bets.

Beware the dangers of optimism.

Optimistic Blinders

I believe that the same processes that underlie risky behavior also contributed to the buildup of a financial crisis. Let's look at how each one of these cognitive distortions contributed to the manic optimism on Wall Street and on Main Street.

1. You evaluate risk by relying on your emotion-If you don't feel anxious, it's not risky

Everyone was feeling good---immediately. The thing that's great about instant gratification is that it works immediately. You feel good right now. And everyone in the scheme was feeling good the minute they participated. How could anything be bad if we are feeling so great?
Here's how it worked.

The borrower felt good getting the house, the banker felt good selling the mortgage (and getting points), Washington Mutual felt good adding to its portfolio, Lehman Brothers felt good selling mortgage backed securities, and we felt good buying them. The politicians felt good because they could take credit for the economy. And, after all, why should they care if a few years later the homeowner loses his house? They got their money and moved on.

It was all emotional reasoning and instant gratification. No one was looking at the evidence and the logic. The evidence was that there were a lot of people who owed money that they might never repay. The mortgage backed securities were based on promises to keep-which would not be kept. And the logic was that this was a Ponzi Scheme.
First one in--- you are the smart one. But don't be the last one out.

2. You estimate risk by relying on unusual dramatic events-if you are not reading about it in the news, it's not risky

There were no unusual dramatic events-until recently. We weren't reading about a credit crisis on the front page-until a few weeks ago. Members of Congress were protecting their interests (until recently) by claiming that Fannie and Freddy were doing a wonderful job. No dramatic bad news---until the bad news was all we heard. There were drips and drabs of bad news-which were not credible to most people, because they kept churning out the money. Who wants to hear someone say, "You're making too much noise", when we are having a party? Leave me alone.

3. You ignore "baseline" information-the real "averages" and "odds"

The baseline information should have been--- how often do people pay back money if they can't afford to pay it back? Optimists would say, "Look, the economy is in great shape. Unemployment is 6 % (not historically that high), we had growth in GDP in the last quarter, and the stock market is still in relatively good shape." The realist would say, "Nice try. But your optimism is due to looking in the rear-view mirror. You are looking at the past. The future is going to be different. Here is why it will be different. You are holding a lot of debt from people who don't have the money to pay it back. And the investment banks are highly leveraged. You are killing the currency."

"But look!", the optimist responds in glee. "I have a lot of money in my 401K".
The gloomsayer says, "You do--for now".
Just wait.

4. You assume that because nothing bad has happened so far that you are safe.

"I've heard these warnings before. Nothing really bad has happened." This is like the happy Russian roulette player. He feels safer with each pull of the trigger. Nothing has happened so far, so I must be safe. Let's raise the bets. I'm feeling lucky.

The roulette player keeps increasing the bets with each click of the trigger. "I must be invincible", he confidently proclaims. "Yes, of course, it's a new economy. It's not the old fundamentals. Forget about that. We are living in a new age. We have new instruments of investment. We have derivatives, mortgage backed securities, swaps, and who knows what else.

Because of this we are safe. It's all so complicated-even I, with my fancy degrees, don't know what the hell I'm saying. Everything is hedged. You've bought insurance with these investments."

And, the optimist spins the barrel of the gun to test his luck.

5. You focus on what you think will happen the next time-"The next cigarette won't kill me".

The wonderful thing about leverage is that the more you have the richer you feel. You borrow against assets that become less valuable. You think, "I can buy that house that is just out of reach". You assume "There is a bigger sucker down the road".

There is. It's you.

6. You ignore "cumulative risk"-how risks build up over time.

As you take more and more risk in your investments and spending you ignore the fact that the entire market is getting riskier. What goes up eventually comes down--on your head. But, you said back then, "It can't be risky. Everyone is doing it, everyone is getting into the market. "After all", you say to yourself, "the price of real estate in South Florida has been rising." That was a couple of years ago. You and your excitable friends were getting closer to the edge of the cliff.

You thought you were climbing a mountain. Ooops.

7. You want to avoid thinking about things that are upsetting-so you avoid thinking of real problems-"I'd rather have a drink"

You don't want to hear about the market, about mortgage backed securities, about the dangers of subprime mortgages, about extending your debt on your credit card. Who wants to hear bad news? Not you. You're an optimist. You believe in the future. Get rich now while the getting is to be gotten. Do it now. Don't bother thinking about the risk. After all, haven't a lot of people made a lot of money already? Where were you? Oh, don't worry, it's not too late. You can take a loan at very low interest with almost nothing down. Here's the wonderful thing about it. You can also take a home equity loan right after you close on the house. Then you'll have even more money in your pocket. Oh, don't listen to those pessimists. They must be depressed. They should be taking medication. They always spoil the fun. Don't bother yourself with those depressing warnings. Don't you believe in yourself?

8. You do not want to experience the discomfort of making a change-"It's too hard".

Can you imagine the resistance that Paulson would have heard if he had come up with this plan a year ago? No one would have believed him. Nothing bad had happened. Real estate prices in New York were still rising. People were still making money. To make a change would have seemed too hard, too politically damaging, too Un-American. Who needs it? The party is still going on. Paulson would have looked too dour.

Ummm. He did give us some warnings in 2007, but no one wanted to hear it.

But now he has been heard. Loud and clear. Finally. Of course, he had to make us realize that the sky was falling. He had to shake us out of our optimism.

Paulson had to close the door after the cattle got out. The bull market was over. The bull..... was over.

9. You prefer to procrastinate about things that are not affecting you right now-"I'll wait until I'm ready".

A year ago no one was being affected. Nothing had hit the fan. Everyone felt rich and clean. Warnings about the coming crisis were out there, but no one was ready to make a change and few people thought it was needed. You can put off doing anything because no one was being affected right now. It was 2007. You can do something when you need to do it. Of course, by that time---today-- (September 2008), it would have a heavy price-tag. A lot of people would lose jobs, lose part of their life savings, there would be more blood under the bridge. But in 2007 the party continued, you could put off doing anything. After all, there is nothing like instant gratification to make you feel safe.

And, after all, if you worked on Wall Street and you were high up on the hog you could count on a golden parachute. And, in any case, you probably believed your own bull.

It's funny in life. Sometimes there's a group of people who continue talking to each other-and they get dumber every minute. They actually believe themselves.

Oh, by the way, here's 700 billion dollars. Don't spend it all in one place. Have a nice day.

 

 

Robert L. Leahy, Ph.D., is the author of Anxiety Free,The Worry Cure and Beat the Blues. He is Clinical Professor of Psychology at Weill-Cornell Medical School. more...

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