Overconfidence and the Financial Crisis

Malcom Gladwell kicked off this morning’s New Yorker summit with a talk about the causes of the financial crisis in general, and of the collapse of Bear Stearns in particular, and started provocatively, by saying that if his diagnosis of the problem is correct, then really “there aren’t any solutions”.

Gladwell’s diagnosis is simple: massive amounts of overconfidence, as revealed by its two most common symptoms, miscalibration and the illusion of control. Both of which can be seen in spades in the person of Jimmy Cayne, whose interviews with William Cohan for House of Cards show a man who’s really very deluded about what Cohan, and Cohan’s readers, are going to think of him.

More generally, said Gladwell,

What’s going on on Wall Street isn’t the result of experts failing to act as experts: it’s the result of experts acting exactly like experts act. It’s not a result of incompetence, it’s a result of overconfidence.

When we look for evidence of miscalibration in people, he said, we find it overwhelmingly in experts. We find it when people are in conditions of great stress and complexity and competitiveness. And we find it overwhelmingly with older, more experienced people, doing difficult things which they feel very strongly about.

Jimmy Cayne, said Gladwell, is the picture of overconfidence — and he’s quite typical when it comes to heads of Wall Street banks. And so, Gladwell concluded:

Our goal is not to enhance the expertise on Wall Street. Expertise they have in spades. Our goal is to rein in the expertise on Wall Street. Wall Street needs to be slower, less competitive, and a lot more boring.

This is undoubtedly true — the difficult thing, of course, is how to legislate it, in a world where banks are falling over themselves to repay TARP funds and start taking on lots of risk again. Here’s Matthew Richardson and Nouriel Roubini writing in the WSJ this morning:

Consider also recent bank risk-taking. The media has recently reported that Citigroup and Bank of America were buying up some of the AAA-tranches of nonprime mortgage-backed securities. Didn’t the government provide insurance on portfolios of $300 billion and $118 billion on the very same stuff for Citi and BofA this past year? These securities are at the heart of the financial crisis and the core of the PPIP. If true, this is egregious behavior — and it’s incredible that there are no restrictions against it.

But if there were restrictions against this behavior in particular, the same banks, or other banks, would find other ways to chase risk, just because they’re so confident that they can make billions of dollars — and get themselves out of their present hole — by doing so. They might even be right: 95% of the time, they probably are right. But that’s the Rubin trade: it works until it doesn’t. And although it’s the easy solution to the problem, it’s also a very worrying solution to the problem, because it just sets up yet another inevitable meltdown at some unknown point in the future.

Comments

[venividivici:]

The simple fact is that hardly anyone on Wall Street ever gets punished in any meaningful way no matter how badly they stuff up.At worst they are sacked and sent on their way with all of their ill gotten gains to lick their wounds.
I remember reading a story about a Canadian guy with a Maths PhD who got a job in an energy trading firm and quickly established himself as a star trader. In one year he made a billion dollars with his daring strategies and took home $100 million in bonuses.The next year it all blew up in his face and he lost $6 billion and was promptly sacked. He then decided to set up his own trading firm and the funds came pouring in from investors eager to share in his "genius". The authorities did step in to stop him continuing but it tells you a lot about the mentality of the people in the industry and why the idiocy that created this financial maelstrom will continue on.

May 05 11:54 AM

[infp:]

What incentive does Wall Street have to change its ways? Bankers who make risky investments are rewarded with obscene levels of compensation. When the risky investments fail, as in this credit crisis, the government rushes in with taxpayer money to cover all the loses. The media dutifully celebrates that we have narrowly escaped a depression and that we should all pile back into the stock market for a new bull market. A new bubble inflates.

May 05 01:15 PM

[jimmy46:]

Stock options have corrupted most of the CEO's in this country and something should be done.

WHY ARE STOCK OPTIONS TAX FREE?

Sure 5 or 10 years down the road they may pay some tax
but the options HAVE REAL VALUE THE DAY THEY ARE GIVEN.

The Black Scholes formula gives a fair value of options.
People who get options should pay tax on them the quarter
they get them.
If they expire worthless later, the person can claim a long term
capital loss.

If anyone doubts the value of stock options, try buying some
with an expiration date just one year out.

May 05 03:03 PM

[Ajax:]

And the issue of Wall Street's connections to politics hasn't even been mentioned. Wall Street plays both parties but contributes about 2X more to Democrats. And now the Democrats are in total power and pretending they are champions of average people. The real problems is that Americans have become so stupid. Is Chuck Schumer really going to go against the bread and butter of his city.

May 05 03:39 PM

[morph366:]

Gladwell's comments about the over-confidence of experts definitely rings true.
One of the primary causes of the bank meltdown was the idea that value at risk could be measured to five decimal places. Until MBA's are taught something different about risk management - and not just ever more complex bits of maths to add on to fundamentally misconceived ways of modelling risk - we shall continue with the experts reaping the rewards for (say) the 95% of the time that the outcomes are profitable and the public sector cleaning up the mess on the other 5%.

The reward/risk ratio is massively unfavourable for the public sector and if, as a culture, we don't learn how to avoid this extreme asymmetry we shall look even more stupid when it does happen again

May 06 09:09 AM

[Robert H. H...:]

As always, Gladwell provides a memorable descriptive observation, but an empty normative prescription.

What does it mean to "rein in" the expertise on Wall Street? And which "experts" should we hire to do it? And how shall we protect ourselves from their "acting like experts".

To paraphrase from the movie Spinal Tap, there's a fine line between "simple" and "simplistic".

May 06 12:13 PM