The Giant Pool of Money

The Giant pool of money

Although it talks about one of the toughest periods of the recent history, the presentation makes a very interesting read. Interesting because it clearly demonstrates how heuristics and biases emanating from such heuristics can lead to a historic crisis. It was also interesting because it presented the situation from the perspective of the whole spectrum of characters that was affected by the crisis. Listening to the program, after almost a decade has passed from the time of the events presented, we get to understand how different heuristics played a significant role in shaping the crisis. The effect of the biases can be felt in the story of every character presented. Hence, while discussing this issue, it makes sense to look at each of these characters and understand the biases they had, understand how these biases influenced their decisions, and identify what could have been done to avoid such fallouts.

Banks/bankers:

One of the very apparent themes in the whole fiasco was the escalation of commitment (or the commitment bias) by the banks. Whenever mortgage market saturated, i.e. when there were not many eligible applicants, banks repeatedly lowered their guidelines and came up with increasingly high-risk products to keep the whole charade running. This unchecked escalation of commitment on the banks' part was one of the significant causes of the housing bubble and its subsequent burst.

Escalation of commitment is often the reason for failures at large corporations. It is the decision makers inability to identify when not to persist with the decision that leads to such situation. Often this happens due to commitment bias, which can be avoided by determining and establishing the limit to the losses up front going into a project. When the set limit is breached, the decision to back out should be automatic. In the case of banks during the housing bubble, a limit to the maximum risk that a particular bank can afford could have avoided the genesis of products like NINA (No income no asset loans).

The Wall street:

When the Federal Reserve lowered the returns on the US bonds, it was natural for the investors to look for high return secure investments. One may also derive that such need for a new investment vehicle gave birth to mortgage-backed securities and CDOs. But what is not very easily understood by many is the reason why such highly educated, smart wall street analysts could not spot the escalating risk with the bad mortgages. These wall street analysts, as data-driven and diligent they are, were looking at the past mortgage data with a bias. They were not looking at the data objectively, but with the bias towards the fact that home rates and mortgages were historically safe. This confirmation bias has led them to underestimate the risk.