Denial: Collective Housing Delusions

• If one person, just one person, does it - they may think he's really sick...
• And if two people, two people do it, in harmony, they may think they’re both [strange]...
• And three people do it, three, can you imagine, three people ... [doing it], they may think it's an organization.
• And can you, can you imagine fifty people ... doing it? They may think it’s a movement.

Source: Arlo Guthrie, Alice’s Restaurant, 1967.

Arlo Guthrie was wrong. Millions of us did it – paid too much for our homes, that is. Now, it all seems strange and we all feel quite sick. But why?

Perhaps, suggests Princeton behavioral economist Roland Bénabou, it was because of the way the housing boom rewarded those who believed and punished those who did not.

MUTUALLY ASSURED DELUSION

Bénabou describes a model of collective reality denial, or groupthink, that he calls Mutually Assured Delusion:

• Whenever an agent benefits from others’ delusions, the agent becomes more of a realist; and
• Whenever an agent is harmed by others’ delusions, the agent denies or attempts to overlook the others’ delusions.

Roland Bénabou, Groupthink: Collective Delusions in Organizations and Markets, March 2009

Enterprises most prone to collective delusions include:

• Those involving new products or markets with a highly attractive upside and a disastrous downside; and/or
• Those in which participants have limited exit options, with outcomes very reliant upon the wisdom or foolishness of others.

These include, Professor Bénabou suggests:

• Enron employees, who had 58% of their pension portfolios invested in company stock; and
• Bear Stearns employees, who held 30% of Bear stock “until the last day... [when they] lost their capital together with their jobs.”

PATTERNS OF DENIAL

Professor Bénabou concludes by providing numerous examples of organizational failures and market meltdowns - many from the current financial crisis. Below are just a few.

Preposterous Probabilities

• “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

Joseph Cassano, AIG Financial Services, Aug 2007; in G. Morgenson, The New York Times - Behind Insurer’s Crisis, Blind Eye to a Web of Risk, 28 Sep 2008.

Information Avoidance

• “Between 2005 and 2007, [Fannie Mae’s]... acquisitions of mortgages with down payments of less than 10% almost tripled... For two years, [Fannie CEO Daniel] Mudd operated without a permanent chief risk officer [“CRO”] to guard against unhealthy hazards.
• When ... that position [was filled] in 2006, the CRO told Mr. Mudd that the company should be charging more to handle risky loans.
• In the following months... [the CRO] warned that some markets were becoming overheated and argued that a housing bubble had formed... But many of the warnings were rebuffed... [The CRO] was among those whom Mr. Mudd forced out of the company during a reorganization in August.”

C. Duhig, The New York Times - Pressured To Take More Risks, Fannie Reached The Tipping Point, 5 Oct 2008.

Overriding Alarms

• Federal Reserve governor [Edward Gramlich]... warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.
• But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed...
• Fed officials repeatedly dismissed warnings about a speculative bubble in housing prices... The Fed was hardly alone in not pressing to clean up the mortgage industry.
• When states ... started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Morgenson & Fabrikant, The New York Times - Countrywide’s Chief Salesman and Defender, 11 Nov 2007.

FORGETTING HISTORY

• Our market system depends critically on trust - trust in the word of our colleagues and trust in the word of those with whom we do business.
• Falsification and fraud are highly destructive to free-market capitalism and, more broadly, to the underpinnings of our society.
• In the latter part of the 1990s ... an infectious greed seemed to grip much of our business community... The trouble, unfortunately, is that the shock of what has happened will keep malfeasance down for a while.
• But human nature being what it is —and memories fade— it will be back. And it is important that at that time appropriate legislation be in place to inhibit activities that we would perceive to be inappropriate.

Alan Greenspan, Testimony before the Senate Committee on Banking, Housing, and Urban Affairs, 16 Jul 2002.

Comments

[socrateazz:]

Nero once fiddled in Rome. The economy burned! Is today similar? Was Nero fiddling with the economy? Or just fiddling around? I wish history was clear on that! Maybe we see a second chance today! history is written to suit those in power.

Mar 04 07:36 AM

[BlueFire:]

How to solve the housing crisis:

Stop all current bailout actions and replace with the following 2 steps:

1) Use bailout money to purchase all foreclosing properties at absolute rock bottom prices.

2) Create a public works program to hire the unemployed to tear down every single foreclosed property in the nation. Every single one, no exceptions.

Kill the cancer, and increase demand for housing by eliminating the supply. Suddenly there is open land to develop with more modern, energy efficient structures.

Those who gained experience on the public dollar learning how to tear down houses can now be hired by private developers to build new houses.

Oh, and all mortgages must be held by the secondary mortgage market with no securitization permitted.

All those who foolishly bought crap just because some idiot stamped AAA on it - well, that is what is meant by caveat emptor!

Mar 04 10:03 AM

[nym:]

So, BlueFire, do you have an estimate of how much your scheme will cost future generations of taxpayers?

Mar 04 11:22 AM

[henarl:]

The author wrote:

"Fed officials repeatedly dismissed warnings about a speculative bubble in housing prices... The Fed was hardly alone in not pressing to clean up the mortgage industry"

Regardless of anything they say, the Fed's primary function is to facilitate a profitable banking industry. Since the banks were making a lot of money as a result of the ongoing mortgage bubble, why would the Fed move to change the situation? They probably thought it could go on forever.

Mar 04 11:37 AM