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.
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
