Giant Pool of Money
In this radio story about the events leading up to the subprime mortgage crisis, it’s clearly demonstrated that a few psychological biases and heuristics were present and played important roles in forming the crisis. The most critical ones I’ve identified are the confirmation bias and the social proof phenomenon in the development of the crisis.
Mainly two types of confirmation bias were observed in the subprime crisis: the confirmation trap as well as anchoring heuristics. Anchoring caused the banks to miscalculate real risks of the mortgages and related MBS/CDO, while the confirmation trap caused most people in the industry to ignore potential risks ...view middle of the document...
Confirmation trap also impacted the development of mortgage crisis. In a market where housing prices were going up and bankers are making tons of money through commissions, people wishfully believed that housing prices would never go down. Hence in the process of risk evaluation and decision making, both banks and mortgage lenders chose evidence that confirmed their belief and ignored factors inconsistent with their beliefs. In other words, “It was the triumph of data over common sense”, driven by their predetermined beliefs that housing prices will only go up.
If it were only for the confirmation bias, the subprime crisis probably would not have had its eventual catastrophic results. The false sense of security and correctness, created by social proof, in other words the “everyone else is doing it” mentality, has had major impact on the final outcome of the crisis.
Through social proof, people often determine the correctness of their opinions, beliefs, and actions by comparing them to those of other people. For instance, Mike Garner, like many other mortgage lenders like him around the country, was under pressure to approve loans that had lower and lower lending guidelines, because they were losing deals to competitors who were willing to lower the bar. At certain point in the process, his boss realized the potential risks and irrationality of those loans, even to the point of “hating” them. However, as they ranted and fought against the lowering guidelines, each time they were instructed to continue simply because other people were offering those loans. Apparently, the fact that many other people are also selling risky mortgages justified the action itself, and provided enough confidence to override years of industry experience as well as basic common sense.
Social proof is not confined among mortgage lenders – it’s also quite prevalent among Wall Street bankers. Even if a bank initially rejected a specific mortgage from Mike Garner, the same bank would usually willingly buy the same mortgage later under the same conditions as long as Mike Garner could find other banks to buy that mortgage. Another example from Mike Francis of Morgan Stanley probably was more...