Wednesday, May 6, 2009

Why Carefree Attitude of Americans and Banks?

Readers Question: What caused the carefree attitude of the American population that led to loose regulations on lending and the eventual collapse of our housing market–and why didn´t most major companies act on historical evidence from previous disasters?

Some ideas that Spring to Mind

Irrational Exuberance. The idea that people get caught up in bubbles and don't like to consider negative side of the story. For more: see: Irrational exuberance and the economics of herding

The End of The Business Cycle.

Francis Fukayama wrote a book in 1991 writing about the triumph of liberal democracy.( This optimistic view has been since questioned). But, in a similar vein analysts in the 2000s, were pointing to what they saw as the end of the business cycle. They pointed out that through the Federal's Reserves control of interest rates, they had managed to avoid boom and bust economic cycles. e.g. the 2001 recession was very short lived and, in the 2000s, inflation (a typical indicator of boom) was absent. Therefore, many felt if inflation is low then we can't be in a boom and so growth is sustainable. The problem was that the boom was building in asset prices and credit markets.

Paul Krugman made a memorable quote
“If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” source: When Greenspan was nearly God
It reflected the strength people felt towards the power of the Federal Reserve in controlling the business cycle.

Passing of Responsibility.
  • One issue that we pick up from the sub-prime crisis is that people were able to pass on ultimate responsibility.
  • Homeowners were sold mortgages by mortgage salesmen. A homeowner may have presumed - well if a bank wants to lend me a mortgage then it must be OK. I mean a bank wouldn't lend me a mortgage if I had no chance of repaying it?
  • But, the mortgage salesmen were paid on commission, so they had a vested interest to sell mortgages whether or not the homeowner could pay it back. However, they didn't have to worry about future repossessions. They were paid on commission.
  • The mortgage companies weren't too worried because they could rebundle their mortgages to 'rocksolid' banks. They might have thought - If banks like the prestigious Lehman Brothers and HSBC are buying our mortgage bundles then we must be doing the right thing.
  • Even the credit rating agencies were giving triple A rating to these bundles of mortgage debt.
  • To summarise there was a sense of diminished responsibility. A feeling - the crowd can't be wrong. Because everyone else was going along with the new type of mortgages / lending e.t.c people felt - who am I to go against the wisdom of the crowd?
  • In fact there were whistleblowers who claimed they warned their banks they were doing the wrong thing but were dismissed for raising warning signals. (e.g. HBOS executive Paul Moore claims he was sacked for acting as whistleblower) Link Guardian
Rationalisation of Irrationality

The human mind is good at rationalising a seemingly irrational concept. E.g. leading mortgage adviser in 2006 Why the Real Estate Boom will not bust (2006) - books they wish they hadn't written.

Government Support

The government sought to extend home ownership and encouraged government agencies Freddie Mac and Fannie Mae to underwrite many of the new homes being built.

Heads You Win Tails You Don't Lose

In the problem of bank bonuses, I mention how bank executives could gain bonuses for taking risky options, but, didn't lose out if their risk failed. Therefore the bonus culture encouraged risky decisions and a culture of short termism which ignored long term risk.

Lack of Education.

Even in banking industry there is little time spent analysing past crashes, the emphasis is how to make profits in the here and now.

See also:

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