Dan Carroll wrote a great post commenting on the roots of the current credit mess, and how it is just another iteration of financial excess gone bad. This is a topic which fascinates me, so I hope Dan doesn't mind if I add some of my thoughts on the topic here.
Charlie Munger, Warren Buffett's brilliant sidekick, has expounded many times on innate human biases and incentive effects. For anyone interested in this topic, I highly recommend you read the transcript of an amazing speech he delivered in 1995, called The Psychology of Human Misjudgement. I have read this speech at least a dozen times and each time I glean something new and valuable. At first it may seem somewhat rambling and confusing, but I think anyone who can get a grip on this material will have a leg up in life on the average Joe who has no idea about these important concepts.
Mr. Munger's treatise is clearly directed towards understanding how biases and incentive effects drive much of human behavior, and are not directed specifically at investing. However, the field of behavioral finance has grown to study many of these same concepts as they apply to financial decisions.
A major point here is that you can never underestimate the power of incentives. One should always ask themselves in any human interaction what the incentives (or reinforcement effects) of the counter party are, especially when money is involved. Munger quips, "I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther."
Another important concept is that of social proof, i.e., the tendency to do what everybody else is doing (as Dan says, humans are herd animals). This is a huge factor throughout anyone's life, from school hallways to the country club and beyond, not to mention in workplaces and boardrooms. If we do something that is applauded or copied or accepted by others, we feel good. It creates huge reinforcement and incentive to do that thing again.
Now I could go on and on here, but I will instead tie this together with the Lollapalooza effect. That's Munger's term for what happens when you have more than one of these biases/incentives acting at the same time - it becomes hugely powerful and a major driver of human misjudgment.
If we look at the mortgage market, there were lollapaloozas everywhere. The brokers and mortgage agents were incentivized to SELL mortgages without considering the consequences of their actions. If they sold more they were rewarded and recognized by their peers. In the old days, there was an incentive to be concerned about the credit quality of the borrower, because the lender kept the mortgage on their books and the loan officer was on the hook to make sure the loan didn't default.
Along came Wall Street with the amazing concept of securitization. If the lenders could sell these mortgages to the financial markets, they could get them off their books, get paid faster and make more loans. On the surface this sounds great because it creates liquidity in the housing market, making it easier for home buyers to get loans.
Beneath the surface it created a massive lollapalooza effect, as the front line brokers and agents were again incentivized to sell with little incentive to worry about what happened down the line. The investors buying the mortgage-backed securities took all the risk, along with the borrowers who were in many cases maneuvered into loans they had no hope of affording down the line (here again social proof among other effects was at work - everybody else was doing it, real estate was going up, etc). It was very easy for the agents and brokers to rationalize their activities (see "incentive-cause bias" in Munger's speech).
Bottom line here is that financial markets and Wall Street are one big ugly ongoing experiment in the psychology of human misjudgement. The incentives are so far removed from the best interests of investors and from the rational consideration of risk that you can't help but have repeated cycles of financial destruction. In general, almost every practitioner in the financial markets is incentivized by a massive lollapalooza effect to sell product, period. There is little incentive to do what is best for investors.
One can quickly see the pattern of excesses followed by financial destruction throughout history. John Kenneth Galbraith, a Harvard Economics professor, wrote a fascinating book in 1990 entitled "A Short History of Financial Euphoria" detailing many of these phenomena. I would like to end this long-winded post with several quotes from this book that are deadly relevant to the current debt crisis.
"There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.?
"the investing public is fascinated and captured by the great financial mind. That fascination derives, in turn, from the feeling that, with so much money involved, the mental resources behind them cannot be less? Only after the speculative collapse does the truth emerge. What was thought to be unusual acuity turns out to be only a fortuitous and unfortunate association with the assets."
"The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets. "
"All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment."
"Speculation buys up, in a very practical way, the intelligence of those involved."
"the speculative episode always ends not with a whimper but with a bang."