Tuesday, November 16, 2010

A bit out of my league...

Ok, so today I want to talk about something entirely different than I usually do.

Basically, I want to write about the psychology of the subprime mortgage crisis in the states. I want to do this, not because I think I am the first person to have thought that this would be a good idea. I am sure somebody has written a book on it and probably been on Oprah or at least the Freakonomics podcast. I think that there’s such a huge human psychological element to all this and I don’t think it’s been explored adequately. I think people have focused on the psychology of the outcome of the financial meltdown (people losing houses and jobs, fear, greed, anxiety) and have focused on individual stories (for example: Planet Money, a free podcast from NPR does a great job of asking real people about what has happened to them as a result of the meltdown.) But I haven’t read a book yet that specifically discusses the psychology that got us to the point of meltdown. The closest thing I’ve read is Michael Lewis’ FANTASTIC book The Big Short (which if you haven’t read it, STOP READING THIS, and get in your car or go to Amazon and buy it. It’s fascinating.) In this book he articulately details the story of those that saw the meltdown coming, how they were able to predict it, and exactly what they did about it.  He hits on some of the psychological details of how people were able to see a pattern in the chaos, but doesn’t really focus on it.

Disclaimer time: I am (as will become increasingly obvious) not an economics expert. I am a person who reads a lot, and because we’ve been overseas for most of this disaster, I’ve been able to watch it from afar. I care very much about my country, and about what’s happened and will happen to small businesses, retirement, and future funding for health care and education in America, so I think I have a vested interest in doing my best to understand what’s going on.

I have found that to discuss anything about this financial meltdown, (which I would’ve called The Big Clusterf&*%k (TBC) had I been Michael Lewis, but to each his own) you have to understand a little bit about why it happened. I think this is an imperative step, and I also think it’s one that most Americans have thus far successfully avoided. Which is very unfortunate. Because that leads to discussions not based on fact, not even on theory, but based entirely on emotion. And while I will discuss that later, I don’t think that emotion serves us well when we are trying to understand something like this.

Again, I am not a financial expert, so I am going to explain this how I understand it. Go and ask your broker/lawyer for the real story.

First things first. TBC happened because of subprime mortgages, we all know that. A subprime mortgage is a mortgage that is given to a borrower that is ‘below ideal’. Now this doesn’t mean that they are a farmer with a 14K income asking for a 2Million loan (although that did happen). This is anyone that has a lower credit rating, therefore has a higher chance of defaulting (not paying) their mortgage a) on time or b) at all. Just because subprime mortgages were a centerpiece to TBC, that doesn’t mean they’re always bad. Initially, they were designed to help people “get a small piece of the American dream”. Help those with poor credit get into a home, which could build equity and eventually help them to improve their credit.  This is point of interest for psychology 1 (POI for PSY 1).

Subprime mortgages were given out by mortgage lenders, not always banks. These mortgage lenders make their money off the top by setting up the mortgage. Therefore, they have no vested financial or personal interest in the loan actually getting paid off, rather they get paid when the loan is made. This is POI for PSY 2.  These lenders then sell the mortgages to banks. Again, taking a little off the top for expenses and whatnot.

The second problem is that all these mortgage loans were made with ‘variable interest rates’ which is exactly what it says it is. The interest rate is one thing at one time and could go up or down (probably not down, but could) depending on a variable interest rate index, which I think is set by the Fed. I can’t find it online from a credible source, so don’t quote me on that. So the interest rate would be 6% when you bought the house, but would skyrocket to 18% 3 years in. This is why there was a housing bubble, which seemed to suddenly burst, but it could’ve probably been predicted had anyone put the pieces together. Everyone started defaulting on their loans when their 3 year grace period was over. Suddenly, they weren’t paying for their houses, but just for the interest. This is POI for PSY 3.

Ok, so now you’ve got a bunch of subprime mortgages that aren’t owned by the mortgage lenders, but rather by various banks. The banks then, in order to have liquidity (cash), sell the mortgages to investors. Here’s where things get kinda messy. The mortgages are packaged. Normally when this happens, mortgages are packaged with a lot of other loans that the bank makes, like car loans or college loans. These are not debt from a single person, but from a variety of sources. Not even always just from the one bank. This is done because it diversifies the package (my new favorite euphemism), which means that, as a whole, the package of loans is safer. It’s safer because there is heterogeneity in the package so people won’t be as likely to suddenly default on a school loan, a car and a house all at the same time. I believe this is the point in the process where the package is renamed ‘Mortgage Backed Security’. I am not sure about that though.The problem started because now, for whatever reason, these packages of loans were mostly mortgages- and above that, mostly sub-prime mortgages.

So the bank sells the MBS to an investment facility. The investor can be other banks, individuals, groups, venture capital firms, etc. Really, anyone wanting to invest, but usually a large company. Now, again, this is where I get a little fuzzy. I think what happens is the MBS’s are split into Tranches based on risk. Tranches (French for slice) is a ‘grouping’ of the MBS’s. so it goes:


Mortgage backed securities (MBS) are rated by national rating agencies such as Moody’s and Standard & Poor’s (of S&P 500 fame). Rating is just like grading, only it’s based on risk of default. The agencies look at what’s in the MBS and say, ‘what is the risk that this won’t be paid off?’ and then grade it. The grading scale is from AAA (the best) to AA to A to BBB to BB to B (worst). AAA means that there is virtually no chance of default. B means, ‘yeah, this is crap. Sorry.’ So these groups of loans are rated and then assigned to a tranche based on risk.

As I said, the ratings are based on risk of default. However, as you can see with all these crappy mortgages all in the same package, the rate of default should be pretty high, right? Well, here’s where things become very fishy.

What started happening is whoever puts together the MBS’s started packaging them in such a way that they looked better than they actually were. This was easy to do because when rating the mortgages, only the AVERAGE risk score for the entire group was examined. AVERAGE. NOT THE MODE. NOT THE MEDIAN. THE AVERAGE. This is important because there could be a few really low risk mortgages in the MBS, and they would bring the whole score up. This is POI for PSY 4.

There is more to this part of the story, but I don’t completely understand it, so I don’t want to discuss it too much here. Suffice to say, there was also a ‘redefining’ of what AAA meant. Basically, things that were formally A grade or even BBB, were now being considered AAA. I don’t understand how this happened, so further research on my part is needed. I think I don’t understand this because it seems so completely backhanded and wrong I can’t wrap my mind around how it happened legally. 

We’re almost there! Don’t go to sleep on me now!

So creators of the tranches (the original investors) then have people invest in the tranches. Within these there is a hierarchy. So there are people who are at the top of the tranche down to those at the bottom of the tranche. However, those at the bottom are still better than those at the top of the next tier lower tranche. The people that have invested at the top of the tranche get paid off first, so when the poor subprime mortgage borrower sends his/her monthly check, a percent goes to the investor at top of the highest (AAA) tranche first, then whatever’s left trickles down the tranche. If anything is left after it’s gone through the AAA tranche, then it goes to the AA tranche and so on…

Phew! Wowsa. OK.

So there are many places where this house of cards could get caught in a slight breeze. Or tornado. Basically, it’s people buying risk.  They are making a bet that someone they don’t know will pay off their mortgage on time, and in the prescribed increments.

This would work, except that it doesn’t. It worked for a long time, but people got cocky. And even more appalling then the rampant cockiness and blatant greed is that people didn’t take the time or make the effort to understand what it was they were buying or selling. I mean, I know hindsight is always 20/20, but when you have someone walk you through the story of how things got the way they are, I don’t understand how you can’t see the problem from a million miles away. Maybe it’s like that Monty Python and the Search for the Holy Grail bit where the guy is running toward the castle and every time the guards look at him he’s still far away and then all the sudden he’s at the gate and clotheslines them both. Or maybe people didn’t understand the meaning of the word ‘variable’.

POI for PSY 1: I think it’s fascinating that ‘The American Dream” (capitals intended) includes owning a house. Americans in the 80’s and 90’s and 00’s believed that it essential to own a house. The government encouraged it, by offering tax incentives to own a house.  News and magazines encouraged home ownership, offering great deals on various appliances NEEDED for YOUR NEW HOME. Commercials showed the typical American family outside of a home with a white picket fence. The commitment to home ownership is quite an emotional one.  Its branded into the psyche of most American children. The goal is to own a house, once you own a house, you’ve made it. Psychologically, renters are people who can’t put down roots. Home-owners are people who are serious about their neighborhoods, who value their community, even attend PTA meetings and take care of their yards. This brings perceived stability to neighborhoods and families that “make sense” to the rest of the neighborhood. The psychological pressure to own a home is tremendous in the US. It’s just what people do.

POI for PSY 2: The point of interest here is how important personal relationships are. As I said, I was listening to Planet Money and the hosts had bought a $1000 toxic asset, so a lower tranche group of MBS’s. They went to meet a guy whose mortgage they had invested in. As it happened, the guy was a 80 year old retiree who had made a ‘strategic default’ meaning that because his perfect credit rating is no longer of the utmost importance at age 80, he defaulted on a $300,000 mortgage. But when the two people who owned his MBS went to meet him, they asked why he stopped paying. He said he couldn’t afford it, and it wasn’t worth it to him. But what I thought was most interesting was what he said next: he said, if I’d know it was you guys that owned the loan I would write you a check right now. How fascinating. He liked the people who’d invested in his mortgage, and felt personally liable to pay the mortgage. But when the investor was a faceless entity, he was able to change is moral creed and allow himself to not follow through on his loan. 

In the past, mortgages were made by local banks and the person who gave you your mortgage probably knew you, did a thorough credit check, checked out the property you were wanting to buy and it’s value and probably checked your references. Now, mortgages are these impersonal things, a transaction, not an interaction. I am not saying that the old way was the best. It was slow and sometimes too personal (I don’t like this guy so won’t give him a loan), but there was an element of human decency in it. People had to interact with each other. You know who had your mortgage and you knew who was loaning you the money to buy your house.  There’s an element of responsibility on the borrower’s side this way. The borrower actually understands and cares where they are putting the loan, because they’re paying back a real person. Not a faceless entity.

POI for PSY 3: The idea of a variable interest rate is such an American creation. The reason why everyone votes for lower taxes for the rich is because most people believe that some day they will be that rich person. Again, the American dream.  I think this belief is akin to the reason why people took out variable interest rate loans. They always want to believe the best- have the most positive possible outlook. We will be making more money in 3 years, or interest rates could go down in 3 years. In psychology, this is also called confirmation bias. Confirmation bias is when people favor information that confirms what they already think. They don’t seek out disconfirming information, rather find all the confirming stuff.

I also think that this idea of actually taking advantage of a 3 year variable interest rate could be cognitive dissonance. Cognitive dissonance is when two conflicting ideas are held simultaneously. People think their choices are correct despite evidence to the contrary. For example: I believe that I will get paid more in 3 years and I just got told that there would be massive layoffs at work.  Cognitive dissonance causes emotional turmoil, and results in self-bargaining and convincing ones self that the evidence is wrong or at least that the possible results of the behaviour probably won’t happen to me. Smoking is the oft used example. I smoke because I like it even though I know that it causes lung cancer, heart disease, obesity, general smelliness, etc.

The cognitive biasing and dissonance in the housing market, I think, had a huge impact in the months and years leading up to the crash. People were convinced they were invincible despite massive evidence to the contrary.

POI for PSY 4: The last point I want to make is about measurement. My friend Cakil always says that statistics is the only weapon that we psychologists have. I think this is true. Using the average instead of the mode or median is ridiculous. There is potential influence of outliers, the mean never tells the whole story, doesn’t give you any information about what’s actually in this group of mortgages…  I am sure that someone much much smarter than I has pointed this out. I don’t want to labor the point more than to say  SERIOUSLY??

I think there’s a lot more to big disasters like this than just what’s on the surface. There was a long lead up to this. If you have spoken to me in the past, you probably know about the ‘Swiss Cheese Model’ of error. Basically, what it says is that errors are lying dormant in a system. The system has layers of defense, but they have holes in them, much like slices of swiss cheese.  Infrequently, these slices or layers are arranged in such a way that an error has a free path through all the layers of defense and takes everyone by surprise. This shouldn’t be the case, because it’s been sitting their laying in wait, but it does. Every time. I think, in the financial meltdown there is something far more fundamental wrong with our system than financial regulations can fix. There’s a psychological issue, a relationship issue, a person to person issue.


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  2. Fascinating read. I'd love to read even more POI's for PSY, because this issue is so chock full of psych.

    The most important thing I take away from your post is that by focusing so much on the outcomes of the meltdown and ignoring the psychological foundations of these sorts of crises we are doomed to let it happen again. But, if we can develop an understanding of the inherent cognitive biases that people have and build a system which takes those biases into account rather than takes advantage of them for profit, then I think we will get much further than more and more regulations.

    The other thing I take away from this is your point that we should have seen this coming. I wonder whether there could be a way of formalising a monitoring process based on psychological insights about how we know people tend to behave in given situations, so that we actually could predict this.

    Finally, I agree that the mean doesn't ever tell the whole story. I'd be even more skeptical of the mode and the median because they would completely hide the outliers which seems just as scary. At the very least any central tendency measure should include a measure of deviation, and ideally the minimum and maximum so that you can flag just how high the risk is.

    Awesome stuff - such an interesting read.