Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis has a really interesting alternative explanation the global financial crisis of 2008: Maybe it wasn’t about financial industry insiders deceiving investors and homebuyers, financial innovations run amok, securitization that allowed mortgage originators to avoid having skin in the game or even about feckless, conflicted rating agencies assigning AAA ratings to junk.
Maybe investors and homebuyers knew exactly what they were doing, had reasonably complete information and made wise decisions at the time, based on circumstances and expectations at the time. In fact, the paper argues, they were reacting rationally to a classic bubble in home prices.
…borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices.
The authors argue that in the early 2000’s, borrowers, bankers regulators, economists–basically everyone–had overly optimistic expectations that home prices would continue to rise. These expectations encouraged people to bid up the prices of homes and lenders to finance with less collateral, less income and less documentation.
Both parties expected to profit by the transaction with little risk. Even if housing payments proved unaffordable, the homeowner could sell their home, pay off the mortgage and make a nice profit. By the same token, ever-higher prices would protect lenders from default because the collateral (the home) backing their loan would prevent a loss.
And yet, it obviously ended badly. There are several key lessons relevant to decision-making:
- We don’t understand financial market dynamics very well, especially how bubbles are created or popped. So, there will always be fundamental uncertainty about how most financial decisions will pan out;
- The uncertainty is so profound, I believe, that we should not even try to assign probabilities to future scenarios. At a casino, we know the odds of rolling a seven. As for future economic/financial scenarios, we really don’t know the odds of anything;
- We can’t rely on our intuitions. Representativeness, groupthink and confirmation biases can prevent us from judging likelihoods accurately. (The authors note that analysts understood how home price declines would affect the value of their investments, they just paid this scenario little heed because the chances seemed so low based on recent history. )
- Forecasts, valuations and analysis must be modest and honest about how little we know about the future. This will allow the decision-maker to seriously consider extreme and adverse scenarios, even if they appear unlikely.
- On page 37, the authors suggest a “financial fire drill“: what if falling home prices prevent you from selling your home for more than the mortgage, say, after a job loss? The authors add, “If this happens and the borrower does not have sufficient precautionary savings, then that borrower is one job loss or serious illness away from default.”
In many cases, making good decisions is about managing risk and acknowledging what we don’t know. Respecting our ignorance about bubbles and how the financial markets, indeed humans as a species, operate, is uncomfortable (ambiguity aversion). Yet, it is a necessary first step in making decisions that avoid intolerable outcomes.