How did it all happen?

As I write this, the dow is down 430 points, below 10,000 for the first time in four years.  Tyler Cowen has published his list of what went wrong, with which I largely concur.  Another way to think about it is as a series of cognitive errors that afflicted everyone:  investors, home buyers, lenders, regulators.  They're standard cognitive errors that so far, no one has a very good way of eradicating:

  • Recency effect:  People tend to overweight recent events in considering the probability of future events.  In 2001, I would have rated the risk of another big terrorist attack on the US in the next two years as pretty high.  Now I rate it as much lower.  Yet the probability of a major terrorist attack is not really very dependent on whether there has been a recent successful one; it's much more dependent on things like the availability of suicidal terrorists, and their ability to formulate a clever plan.  My current assessment is not necessarily any more accurate than my 2001 assessment, but I nonetheless worry much less about terrorism than I did then.
  • Bandwagon effect:  People tend to believe that something is a better idea if a lot of other people are doing it.  In essence, they are trying to free ride on other people's analysis, on the assumption that someone must have thought this thing out.  This has its uses--we don't all need to learn every hard lesson for itself.  But in markets it produces herding behavior, which makes outcomes more extreme on both the upside and the downside.  In other words, we get booms and busts.  In the professional world, this is exacerbated by the fact that you're less likely to get fired if you fail at the same time everyone else does.
  • Availability heuristic:  People tend to overweight data that comes easily to mind, which is to say vivid (extreme) and recent examples.
  • Beneffectance:  People tend to view success as a result of their own actions, while they view failures as having been due to factors largely outside of their control.
  • Confirmation bias:  The tendency to look for data that confirms your theory, rather than data that falsifies it.  Yes, we all know how this works in politics, but it's a much broader problem.  People will repeatedly devise tests that give positive proofs of their theories, but much less often devise tests to falsify them.
  • Hyperbolic discounting:  People value small short-term payoffs more than much higher long-term payoffs.
  • Optimistic bias:  People tend to be overconfident about their own abilities and the outcome of their plans.  Something like 90% of people think that they are above average drivers less likely to get into an accident than the average joe.  This is so pervasive that there is actually a scientific name for the few people who accurately assess their own future, their abilities, and what other people think of them:  clinically depressed.
  • Overconfidence bias:  Relatedly, people are too confident in the accuracy of their predictions.  When asked to estimate a range of possibilities where the true outcome is 95% likely to fall within that range, people's guesses are wrong 40% of the time.

As I see it, these affected everyone who was involved in the markets.

Homebuyers looked at 50 years of basically steadily rising home prices, with few and small declines, and concluded that rising home prices were some kind of natural law. In fact, the run-up in home prices was the idiosyncratic result of a lot of factors:  the move to long-term self-amortizing mortgages; the home mortgage interest tax deduction, which became steadily more valuable as income tax rates rose; the steady decline in nominal interest rates, which lowered monthly house payments for any given home price; severe regulatory contraction of supply in a few areas.

As capital flooded into the US debt markets in the wake of the Asian financial crisis--and I think that Asian savers and central banks bear much more of the responsibility for the credit bubble than can be plausibly pinned on either Alan Greenspan or Ben Bernanke--real interest rates also fell, which made housing an even better deal.  The recency effect kicked in:  as the bubble grew, it began to seem more, not less, likely that home prices would continue to rise.  The bandwagon effect also reared its ugly head.  Everyone else was buying a house on potentially catastrophic terms, so it must be safe! 

Any self-introspection on the safety of the housing market was also plagued by bias.  Examples of falling house prices were not available to memory; spectacular coups reaped by coworkers on a two bedroom fixer-upper were.  And in testing their theory of future house prices, people looked for reasons that housing prices might rise--the many amenities of homeownership wherever they happened to live--rather than thinking of reasons that it might fall.  Besides, the memory of the stock market crash was extremely recent and vivid.  People began to see a home less as a place to live than an investment, a safe alternative to the risky securities market.

Once they had decided that it was likely to rise, they were overconfident in this assessment, which made them rather careless about the terms under which they signed mortgages.

Lenders went through much the same pattern.  The revolution in credit scoring that took place in the 1990s actually did make lenders better at predicting default risk.  As we moved into the current decade, however, the steady rise of home prices started to skew the numbers.  Borrowers who historically might have defaulted simply sold their house into a rising market, recouping at least the value of their mortgage.  Or they refinanced, getting much better terms because the loan now represented a smaller proportion of the overall value of the house, meaning that lenders were more likely to get all their money back.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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