ABSTRACT
The root cause of the financial crisis that erupted in 2008 is psychological. In the events which led up to the crisis, heuristics, biases, and framing effects strongly influenced the judgments and decisions of financial firms, rating agencies, elected officials, government regulators, and institutional investors. Among the many lessons to be learned from the crisis is the importance of focusing on the behavioral aspects of organizational process.
In this article, I present evidence that psychological pitfalls played a crucial role in generating the global financial crisis that began in September 2008. The evidence indicates that specific psychological phenomena – reference point–induced risk seeking, excessive optimism, overconfidence, and categorization – were at work. I am not saying that fundamental factors, such as shifts in housing demand, changes in global net savings rates, and rises in oil prices, were not relevant. They most certainly were relevant. I suggest that specific psychological reactions to these fundamentals, however, rather than the fundamentals themselves, took the global financial system to the brink of collapse.
To what extent did analysts see the crisis coming? In late 2007, four analysts (among others) forecasted that the financial sector would experience severe difficulties. They were Meredith Whitney, then at Oppenheimer; Dick Bove, then at Punk Ziegel & Company; Michael Mayo, then at Deutsche Bank; and Charles Peabody at Portales Partners (see Berman 2009). For example, in October 2007, Mayo issued a sell recommendation on Citigroup stock. Two weeks later, Whitney issued a research report on Citigroup stating that its survival would require it to raise $30 billion, either by cutting its dividend or by selling assets. More than any other analyst, Whitney raised concerns about the risks posed by the subprime mortgage market – and by the attendant threat to overall economic activity.
How timely were analysts in raising the alarm? As it happens, public markets had begun to signal concerns early in 2007. At that time, the VIX was fluctuating in the range 9.5 to 20, having fallen from its 2001–2002 20 to 50 range. On 27 February 2007, an 8.8 percent decline in the Chinese stock market set off a cascade in the global financial markets. In the United States, the S&P 500 Index declined by 3.5 percent, which was unusual during a period of relatively 270low volatility. Among the explanations that surfaced in the financial press for the decline in U.S. stocks was concern about weakness in the market for subprime mortgages.
In a book published in 2008, I argued that psychological pitfalls have three impacts that analysts should be aware of (Shefrin 2008b): First is the impact on the pricing of assets, particularly the securities of firms followed by analysts. Second is the impact on decisions by corporate managers that are germane to companies’ operational risks. Third is the impact on the judgments of analysts themselves.
The financial crisis contains illustrations of all three impacts. I use five specific cases to explain how psychological pitfalls affected judgments and decisions at various points along the supply chain for financial products, particularly home mortgages, in the crisis. The cases involve (1) UBS, a bank; (2) Standard & Poor’s (S&P), a rating firm; (3) American International Group (AIG), an insurance company; (4) the investment committee for the town of Narvik, Norway, an institutional investor; and (5) the U.S. SEC, a regulatory agency.
I use these cases to make two points. First, common threads link the psychological pitfalls that affected the judgments and decisions of the various participants along the supply chain. In this respect, a relatively small set of psychological pitfalls were especially germane to the creation of the crisis. The key mistakes made were not the product of random stupidity but of specific phenomena lying at the heart of behavioral finance.
Second, the major psychological lessons to be learned from the financial crisis pertain to behavioral corporate finance (Shefrin 2005). Many readers think of behavioral finance as focusing on mistakes made by investors, but issuers (corporations, governments, and so on) are people too and are just as prone to mistakes; behavioral corporate finance focuses on their side of the equation. Specifically, behavioral corporate finance focuses on how psychology affects the financial decisions of corporate managers, especially those in markets that feature mispricing.
The key decisions that precipitated the crisis need to be understood in the context of behavioral corporate finance. Moreover, behavioral corporate finance offers guidelines about what to do differently in the future. For analysts, the general lesson to be learned is the importance of including a behavioral corporate perspective in their toolbox.
The five cases are intended to be representative. For example, UBS is hardly unique among investment banks, as the fates of Lehman Brothers, Merrill Lynch, and Bear Stearns illustrate. As discussed later in the paper, Citigroup engaged in strategies similar to those pursued by the investment banks. Indeed, in April 2009, the Washington Post reported that banks relied on intuition instead of quantitative models to assess their exposure to a severe downturn in the economy. This statement was based on interviews with staff at the Federal Reserve Bank of New York and the U.S. Government Accountability Office.
The source material for the five cases is varied. For UBS, the main source is an internal document from the firm itself. For the SEC, the main source material is an audio transcript from an SEC meeting. For the other three cases, the main source material is press coverage. Material from press coverage features both strengths and weaknesses. One of the key strengths is that information comes from the level of the individual decision maker, as revealed in interviews with decision makers and their colleagues. From a behavioral perspective, this level of detail is invaluable. One of the key weaknesses is that press coverage is less than fully comprehensive and is prone to distortion. In this regard, I discuss an example illustrating a case of distorted coverage.
