Human frailty caused this crisis

By Richard Thaler and Cass Sunstein

Published: November 11 2008 19:46 Last updated: November 11 2008 19:46

Mea culpas are rare these days. In a debate with John Kerry in 2004, President George W. Bush fa­mously could not name a single mistake he had made in his first term. So it is both noteworthy and commend­able that Alan Greenspan, the former US Federal Reserve chairman, fessed up that he had failed to anticipate the financial crisis.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief,” he said. Mr Greenspan had faith that banks were prudent enough to make sure they were not lending money cheaply to people who could not pay it back. Yet that is what happened. As Mr Greenspan says of securities based on subprime mortgages: “To the most sophisticated investors in the world, they were wrongly viewed as a ‘steal’.”

Why did Mr Greenspan, along with the rest of the world’s regulators, fail to foresee that this could happen? We think their mistake was to neglect the role of human nature. To prevent future catastrophes, regulators should focus explicitly on how to provide safeguards against two all-too-human frailties explored by decades of work in behavioural economics: bounded rationality and limited self-control.

The standard (non-behavioural) econ­omic model has greatly influenced regulators. In that model, economic agents (econs for short) choose optimally, no matter how hard a problem they face. They play chess as well as they play tic-tac-toe. The problem with this approach is that the world is populated by humans, not econs. Humans are not stupid, but when things get complicated they flounder: they suffer from bounded rationality.

This brings us to an aspect of the financial crisis that has not received the attention it deserves: the financial world has become more complex in the past two decades. Not so long ago, most mortgages were of the 30-year fixed-rate variety. Shopping was simple: find the lowest monthly payment. Now they come in countless forms. Even experts have trouble comparing them and a low initial monthly payment can be a misleading guide to total costs (and risks). A main cause of the mortgage crisis is that borrowers did not understand the terms of their loans. Even those who tried to read the fine print felt their eyes glazing over, especially after their mortgage broker assured them that they had an amazing deal.

Yet growing complexity on the borrowers’ side was trivial compared with what was going on at the banks. Mortgages used to be held by the banks that initiated the loans. Now they are sliced into mortgage-backed securities, which include arcane derivative products.

Many economists have argued that even if individual consumers suffer from bounded rationality, markets will be set right by specialists who can figure out even the most complex problem. But, as Mr Greenspan now ­concedes, even these sophisticated investors got things badly wrong.
The second problem involves self-control. Econs do not suffer from self-control problems and so “temptation” is not a word that exists in the economists’ lexicon. As a result, regulators have not thought much about the problem. But when the dessert cart comes by, we humans often cave in. The next thing we know, we are fat. This crisis was fuelled by the seemingly irresistible temptation to refinance the mortgage rather than pay it off. Falling interest rates, rising home prices and aggressive mortgage brokers made re­financing (and second mortgages) seem like the apple in the Garden of Eden. When home prices fell and interest rates increased, the party ended.

Regulators therefore need to help people manage complexity and resist temptation. A potential response to complexity would be to require simplicity – for example, by allowing only the standard 30-year fixed-rate mortgages. This would be a big mistake. Eliminating complexity would stifle innovation. A TiVo is a more complicated product than a VCR, but it is also better.
A superior approach is to improve disclosure. One reason a TiVo is better than a VCR is that it is easier to use. Regulators can reduce the chances of a future meltdown by making it easier to understand financial products. Agg­ressive steps should be taken to imp­rove disclosure – for example, with mortgages, fine-print disclosure should be supplemented by machine-readable files enabling third-party websites to translate hidden details of the terms. Mandatory transparency for investment banks and hedge funds would also help.

The government and the market should try to deal with temptation. We hope that lenders will ask families to have done some saving in order to qualify to buy a home. Conscientious lenders could also nudge people to get off the refinancing merry-go-round, by suggesting that the term of the loan be shortened when a loan is refinanced. More ambitiously, private and public institutions could try to reintroduce an old social norm: try to pay off the mortgage sooner rather than later, and at the latest by the time you retire.

Greed and corruption helped create the crisis, but simple human frailty played a vital role. We will not be able to protect against future crises if we rail against greed and wrongdoers without looking in the mirror and understanding the potentially devastating effects of bounded rationality and limited self-control.

Richard Thaler is professor of behavioural science and economics at the Graduate School of Business, University of Chicago. Cass Sunstein is Felix Frankfurter professor of law at the Harvard Law School. They are the co-authors of ‘Nudge’ (Yale University Press)

Copyright The Financial Times Limited 2009

Bill Gross

First-timer home buyers like low rates | Vancouver, Canada | Straight.com

This is an outrageous story of massive risk taking by a first time home buyer. I shudder to think what the consequences of these actions might be for them - bankruptcy, divorce, depression?

If this is representative of most first time buyers right now then this market is doomed.

First-timer home buyers like low rates | Vancouver, Canada | Straight.com

Shared via AddThis

Bill Gross on the New Normal

Bill Gross, the “Bond King” is going to great lengths to get us to understand that the world is in a state of reversion to what he and El-Erian, his co-chief at PIMCO coined as the “New Normal” 3 months ago, in his latest missive - “Bon” or “Non” Appétit?.

Our economy which once feasted, no, binged, unable to stop itself, on debt and leverage, and on the basis that home and other asset prices would rise to the sky, is now fasting, cleansing itself of the fat that accumulated, and it is a long-term process that will take many years to complete.

Here are some of the highlights from the letter, which you may download here:
Gross re-iterates the “New Normal” - Its starting to sound a lot like “The Emperor’s New Clothes“:

Our economy’s lights, if not switched off in a rehash of the 1930s Depression, have certainly been dimmed in a 21st century version likely to be labeled the Great Recession. Much like John McSherry, U.S. and many global consumers gorged themselves on Big Macs of all varieties: burgers to be sure, but also McHouses, McHummers, and McFlatscreens, all financed with excessive amounts of McCredit created under the mistaken assumption that the asset prices securitizing them could never go down. What a colossal McStake that turned out to be. Now, however, with financial markets seemingly calmed and an inventory-based recovery in store for the balance of 2009, there is a developing optimism that we can go back to the lifestyle of yesteryear. PIMCO’s driving thesis however, if not a juxtaposition, is succinctly described as a “new normal” where growth is slower, profit margins are narrower, and asset returns are smaller than in decades past based upon the delevering and reregulating of the global economy, which in turn should substantially inhibit the “gorging” of goods and services that we grew used to in decades past.

Forecasts based on econometric models inevitably miss these secular/structural breaks in historical patterns because it is impossible to quantify human behavior, and long-term trends involving risk-taking and in turn derisking are decidedly human in their origin. Bell-shaped curves with Gaussian/random distributions fail to anticipate that human beings do not make decisions by chance or independently of each other, but in many cases in reaction to one another. Humanity’s personal and social computers appear to be programmed that way. And so, instead of “normal” distributions, economists and investors must learn to be on the lookout for “black swans,” and if not, then certainly “fat tails,” which differ from the measurement of natural phenomena accepted in science. “New normals,” flatter-shaped bell curves, and structural shifts in previously accepted standards become not only possible, but probable as human nature reacts to itself and its prior behavior. The efficient market hypothesis was always dead from the get-go, but academic tenure and Nobel prizes were food for the unwilling or perhaps unthinking.

Others are starting to wonder about the emperors new clothes, the “green shoots”:
I was impressed this weekend by an article in the Op-Ed section of The New York Times by staff writer Bob Herbert. “No Recovery in Sight” was the heading and his opening sentence asked, “How do you put together a consumer economy that works when the consumers are out of work?” That is really all one needs to ask when divining our economy’s future fortune. Unless an optimist can prescribe how to put Humpty Dumpty back together again and shuffle him/her back to work then there can be no return to an “old normal.” As unemployment approaches 10%, what is less well publicized is that the number of “underutilized” workers in the U.S. has increased dramatically from 15 to 30 million. Those without jobs, as well as those individuals who only work part-time and have become discouraged and stopped looking, total 30 MILLION people. The number is staggering. Commonsensically, one has to know that many or most of these are untrained for the demands of a green-oriented, goods-producing future economy. Imagine a welding rod in the hands of an investment banker or mortgage broker and you’ll understand the implications quicker than any economist using an econometric model.

Fifteen Words to describe the era that led us to our current economic crisis:
The supersizing of financial leverage and consumer spending in concert with the politicizing of deregulation describes in fifteen words our most recent brush with irrational behavior and inefficient markets. Greed will come again. But for now, the trend is the other way and it promises to persist for a generation at a minimum. The fact is that American consumers have suffered a collapse in wealth of at least $15 trillion since early 2007. Global estimates are less reliable, but certainly in multiples of that figure. And when potential spenders feel less rich by that much, the only model one can use to forecast the future is a commonsensical one that predicts higher savings, lower consumption, and an economic growth rate that staggers forward at a new normal closer to 2 as opposed to 3½%. There’s no magic in that number, and no model to back it up, just a lot of commonsense that says this is how people and economic societies behave when stressed and stretched to a near breaking point.

Where do we go from here:
Investors who stuffed themselves on a constant diet of asset appreciation for the past quarter-century will now be enclosed in a cage featuring government-mandated, consumer-oriented fasting. “Non Appétit,” not Bon Appétit, will become the apt description for the American consumer, and significant parts of the global economy, including the U.S. Because this is so, short-term policy rates will be kept low for longer than cyclical norms, and the outlook for risk assets - stocks, high yield bonds, and commercial and residential real estate will involve just that - risk. Investors should stress secure income offered by bonds and stable dividend-paying equities. Consumer Cuisinart consumption is a relic of the past.