Pragma Synesi – interesting bits

Compendium of interesting bits I come across, with an occasional IMHO

Why Smart People Often Do Stupid Things

Trying to explain the plentiful financial screw-ups that recently have come to light. From Benefits Canada:

Deconstructing “Stupidity”: Why Smart People Often Do Stupid Things

December 23, 2008 | Jeffrey Gandz

Any observer of the parlous state of financial markets and its impact on the global economy might be reminded of Albert Einstein’s words: “Only two things are infinite, the universe and human stupidity—and I’m not sure about the universe.”

While there are many technical explanations for the current financial markets mess, and while some of the central figures such as Alan Greenspan are at least admitting that they may have underestimated the amount of leverage, or overestimated the willingness of the major financial institutions to control their own profligacy, for many people there remains a central question: Why did so many supposedly smart people—executives, economists, entrepreneurs, directors, regulators, investors—do so many seemingly stupid things? Why did so many individuals and organizations get so far in over their heads? What made them think that one hundred or one thousand times leverage was sustainable? Why did they use credit swaps without understanding the counterparty’s risk? Why did they ignore the clear warnings over many years that this housing-induced credit bubble was building and would almost certainly burst? As a lesser luminary than Einstein, namely Dr. Phil, would say, “What were they thinking?”

This was not a situation in which everyone just “got it wrong.” There were better-run financial institutions that did not touch the toxic debt with which so many others loaded up their balance sheets. Nor did they engage in complex, off-balance sheet financing. Therefore, they did not have write-downs. There were investors who recognized all the danger signs of previous bubbles and moved their money out of the stock markets well in advance of the summer slowdown and October collapse. There were pension funds that recognized the rating agencies’ conflicts of interest and the over-statement of credit-worthiness of various debt instruments, and who moved their funds into true investment-grade vehicles.

But many of the largest financial institutions in the world, many central bankers and prominent economists, indeed whole countries such as Iceland, did get it wrong. And when the markets collapsed as dramatically as they did, even those who were not implicated in the foolishness were affected by it.

No Simple Explanation

The number-one candidate in the blame game is “greed.” But while certainly a factor, it is by itself, too simple an explanation. It denies the fact that many of the same people at the center of these financial machinations were generous philanthropists, supporters of good causes, active in their communities. Some had given up highly paid roles in the private sector to do public service. There were many who did not stand to benefit personally from the risky investments they made yet they made them anyway. Although greed was a factor, fingering it as the explanation just doesn’t hold up to close scrutiny.

Nor do I suspect that criminal behavior had much to do with this situation, although there will undoubtedly be findings of criminal or civil fraud, once the legal wrongdoings of this tangled web emerge.

Nor would a lack of skills in risk management be a primary cause of this debacle. Companies such as Merrill Lynch, AIG, Wachovia, Bear Sterns, and Lehman Brothers had no lack of such skills, although some of the smaller banks and CFOs and treasurers of smaller companies that parked surplus cash in asset-backed commercial paper or CDOs may have been in way over their heads.

When the dust settles, we will likely find a much more prosaic explanation: good, old-fashioned “stupidity.” This “stupidity” does not connote a lack of intellectual capacity; many of the players in this game were people who had achieved high levels of academic excellence and had previously been outstanding performers in the worlds of business and government. To understand “stupidity” it is necessary to deconstruct it and to show that it can subvert even the keenest intellect under certain conditions.

The Alchemist’s Spell

For every dollar of toxic debt that was floated on the market, there had to be a buyer, at least until the market for these CDOs, SIVs, ABCP, etc. collapsed. Throughout history, we have seen the power of alchemists’ promises to turn lead into gold, achieve cold fusion, and so on.

This is what the subprime mortgage situation was all about. Some irresponsible, perhaps unprofessional players in the mortgage industry sold people houses they could not afford on terms that clearly misled them about their future repayment obligations. Then a few persuasive alchemists—AKA financial engineers—convinced a larger number of investment bankers and wholesale money market managers, insurers and investors that a basket of highly dubious mortgages could be mixed with good mortgages, and that a substantial portion of the resulting basket could be sold as high-grade securities, and that derivatives of those high-grade securities would themselves be high-grade securities. Abracadabra…lead becomes gold and this gold was sold all over the world to thousands of corporate and individual investors in a “globalized” financial services industry.

Alchemists have always had appeal for the greedy, the naïve and the lazy—those who really do believe that you can get something for nothing without stealing it and those who are not prepared to work hard, do their own due diligence and try to really understand what’s going on. The lure of an additional 10 to 20 basis points proved irresistible to many people, from individual money market managers, to treasurers of municipalities, to companies with some cash saved up for a rainy day or some future investment.

But it’s a perverse irony that these types of investments are also most appealing to those who have to work hard for the money they make, which is why so many investment scams recruit doctors, dentists and professionals who make their money on a fee-for-service basis. They are lured by the prospect of making money without having to work for it. Something for nothing—or at least for not much—has a fascinating appeal for those who have had to work hard for much of what they have.

Individual and Collective Hubris

In the years 1993-2008, with a blip in 2001-2003, we have been living in a growing economy, albeit one fueled by increased personal indebtedness. So many in the financial services industry, especially in investment banking, got so used to success that they could not envisage failure. They felt invulnerable, superhuman, and impervious to even the most fundamental laws of economics. Their schemes for making money became more and more audacious; subprime mortgages morphed into highly leveraged CDOs; derivatives of these became CDOs-squared with multiples of that leverage. The party was going on forever and the piper never had to be paid – or so they thought.

Highly cohesive and previously successful groups suffer from a kind of collective hubris, or “groupthink”, which blinds them to warning signs of potential danger and desensitizes them to anyone within or outside the group who might raise concerns about group decisions or actions. They stereotype, denigrate and demonize anyone inside or outside their immediate circle who may think that what they are doing is ill conceived or just, plain wrong. There were many who warned of the grave dangers being courted by those building financial houses of cards on top of a financial bubble, from Nobel Prize-winning economists to former policy makers. There were people inside banks who rang cautionary alarms but whose views were rejected as non-entrepreneurial or too risk averse and there were e-mails flying around the rating agencies that frankly stated that much of this financial engineering was a chimera but these warnings did not prevail with key decision-makers.

Risk-Reward Asymmetry

There is an old saying that “good bankers get a return on their money but also make sure that they get their money returned!” However, over the last twenty years, the compensation of many in the financial services field has not been based on this. In many organizations they got substantial amounts of money as bonuses based on short-term financial results and short-term performance of stock options or restricted stock. If those stock prices had a high degree of risk built into them by the actions those leaders had taken to achieve short-term performance, this risk was distributed to all stockholders or left with the remaining stockholders when those who had been rewarded had cashed in.

That boards of directors allowed this to happen is one of the most egregious and transparent failures of corporate governance in recent years and lies at the root of the anger, disgust and contempt that many people feel about the state of executive compensation in those companies that failed or that have had to be rescued at substantial risk or cost to taxpayers.

Too Much Opportunity, Too Little Diligence

One of the most eye-opening findings from this financial morass is that financial paper-rating companies were being paid to rate paper by those issuing the paper. Those same issuers then benefited substantially from the ratings that were assigned. Many enterprises and individuals relied on such ratings to make their own investments. Some—individual investors—may have been surprised at the crassness, cynicism or cupidity of the rating agencies; but many of the professional investors knew of this baked-in conflict of interest yet trusted the rating agencies enough to sell paper based on their ratings.

Why? One hypothesis is that they willingly participated in the commercial equivalent of a party game. They knew the securities were highly questionable but believed that if they kept passing them on to others, often in the form of financially engineered products, they would not be left holding the hot potato when the music stopped. Another hypothesis is that they were so tempted and seduced by the seemingly endless opportunities to keep making money that they just failed to exercise duty of care. They didn’t do their homework. They put their trust in people who were themselves compromised because they were just too busy chasing multiple opportunities to perform the required due diligence.

This is not an unusual behavioral consequence of presenting many attractive choices to someone at the same time. The more choices, the less discriminating people are and the less they exercise caution or diligence in selecting among them.

The Smart People

There were those financial institutions and individuals—executives, managers, directors, and investors—who did not get caught up in the hype and excesses of the financial markets of the last decade, and will get through this current mess reasonably unscathed. They approached this catastrophe-in-waiting with good, practical common sense.

• They didn’t get involved with what they did not understand either as investors or sellers of investment products to others.
• They did their homework on those things that really mattered.
• They didn’t trust advisors unless they really know their expertise and were satisfied that they were working in their interest rather than in the interest of someone who was trying to sell them something.
• They understood that you don’t get something for nothing in this world, that increased reward came with increased risk, and they resisted the alchemists’ spells.
• They didn’t allow past successes to blind them to the risks in every new decision.
• They curbed the desire of many of their less experienced and aggressive staff to get involved in the more complex financially engineered products and put effective controls in place to ensure that they didn’t.

The Ultimate Stupidity or an Age of Reasonableness?

It will take years for the real cause and effect analyses of this financial meltdown to be completed and, even then, there will be questions about “who did what and why.” The greatest “stupidity” of all would be failure to take to heart philosopher George (Jorge) Santayana’s warning: “Those who cannot remember the past are condemned to repeat it.”

Lessons have been—indeed are being—learned from this mess but it is not a given that these lessons will stick. Asset bubbles have come and gone in the past; the dot com era that spawned the insane rise in the Nasdaq, the Asian property asset value collapse and the Long-Term Capital Management fiasco are recent rather than ancient history.

Will the excesses of the last few years be repeated or will we have a smarter approach to regulation, better governance, and better risk management? Politicians, central bankers and even some leading lights in the financial services industry are making the right kinds of noises. For the sake of those whose pensions, savings and future hopes of financial freedom have been so badly affected by the collapse of the housing and financial markets, and the recession it appears to have caused, one can only hope so.

Jeffrey Gandz is Professor, Richard Ivey School of Business, University of Western Ontario, and Managing Director, Program Design, Executive Development. This is an excerpt of an article that appeared in the November/December 2008 edition of Ivey Business Journal.

To comment on this story, email jody.white@rci.rogers.com.

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December 24, 2008 - Posted by | behaviour, economics, investing | ,

3 Comments »

  1. Cold fusion has been replicated by hundreds of mainstream labs, and these replications have been published in major, peer-reviewed journals. See:

    http://www.lenr-canr.org/

    Before commenting on this — or any other — scientific research, I suggest you first read the literature. Making unfounded assertions about scientific research that you know nothing about is a good example of a smart person doing a stupid thing.

    – Jed Rothwell
    Librarian, LENR-CANR.org

    Comment by Jed Rothwell | December 25, 2008 | Reply

    • Your comment has absolutely nothing to do with the main subject of the article. I suggest you read the article before you make a comment on it.

      Comment by pragmasynesi | December 30, 2008 | Reply

  2. I think the failure of Lehman’s corporate governance was evinced in back in the summer of 2008 when the top execs viewed the market rather than the stockholders as “demanding that we hold ourselves accountable,” according to Skip McGee. I’ve just finished a blog post arguing that while self-accountability is a laudable goal, we can’t (or shouldn’t) rely on it. In fact, “holding ourselves accountable” suggests the absence of accountability through corporate governance.

    Comment by euandus | October 22, 2009 | Reply


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