Sunstein and Thaler on the origins of the financial crisis

By Richard Thaler and Cass Sunstein

(Originally published in the Financial Times, November 11, 2008, under the headline “Human frailty caused this crisis”.)

Mea culpas are rare these days. In a debate with John Kerry in 2004, President George W. Bush fa­mously could not name a single mistake he had made in his first term. So it is both noteworthy and commend­able that Alan Greenspan, the former US Federal Reserve chairman, fessed up that he had failed to anticipate the financial crisis.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief,” he said. Mr Greenspan had faith that banks were prudent enough to make sure they were not lending money cheaply to people who could not pay it back. Yet that is what happened. As Mr Greenspan says of securities based on subprime mortgages: “To the most sophisticated investors in the world, they were wrongly viewed as a ‘steal’.”

Why did Mr Greenspan, along with the rest of the world’s regulators, fail to foresee that this could happen? We think their mistake was to neglect the role of human nature. To prevent future catastrophes, regulators should focus explicitly on how to provide safeguards against two all-too-human frailties explored by decades of work in behavioural economics: bounded rationality and limited self-control.

The standard (non-behavioural) econ­omic model has greatly influenced regulators. In that model, economic agents (econs for short) choose optimally, no matter how hard a problem they face. They play chess as well as they play tic-tac-toe. The problem with this approach is that the world is populated by humans, not econs. Humans are not stupid, but when things get complicated they flounder: they suffer from bounded rationality.

This brings us to an aspect of the financial crisis that has not received the attention it deserves: the financial world has become more complex in the past two decades. Not so long ago, most mortgages were of the 30-year fixed-rate variety. Shopping was simple: find the lowest monthly payment. Now they come in countless forms. Even experts have trouble comparing them and a low initial monthly payment can be a misleading guide to total costs (and risks). A main cause of the mortgage crisis is that borrowers did not understand the terms of their loans. Even those who tried to read the fine print felt their eyes glazing over, especially after their mortgage broker assured them that they had an amazing deal.

Yet growing complexity on the borrowers’ side was trivial compared with what was going on at the banks. Mortgages used to be held by the banks that initiated the loans. Now they are sliced into mortgage-backed securities, which include arcane derivative products.

Many economists have argued that even if individual consumers suffer from bounded rationality, markets will be set right by specialists who can figure out even the most complex problem. But, as Mr Greenspan now ­concedes, even these sophisticated investors got things badly wrong.

The second problem involves self-control. Econs do not suffer from self-control problems and so “temptation” is not a word that exists in the economists’ lexicon. As a result, regulators have not thought much about the problem. But when the dessert cart comes by, we humans often cave in. The next thing we know, we are fat. This crisis was fuelled by the seemingly irresistible temptation to refinance the mortgage rather than pay it off. Falling interest rates, rising home prices and aggressive mortgage brokers made re­financing (and second mortgages) seem like the apple in the Garden of Eden. When home prices fell and interest rates increased, the party ended.

Regulators therefore need to help people manage complexity and resist temptation. A potential response to complexity would be to require simplicity – for example, by allowing only the standard 30-year fixed-rate mortgages. This would be a big mistake. Eliminating complexity would stifle innovation. A TiVo is a more complicated product than a VCR, but it is also better.

A superior approach is to improve disclosure. One reason a TiVo is better than a VCR is that it is easier to use. Regulators can reduce the chances of a future meltdown by making it easier to understand financial products. Agg­ressive steps should be taken to imp­rove disclosure – for example, with mortgages, fine-print disclosure should be supplemented by machine-readable files enabling third-party websites to translate hidden details of the terms. Mandatory transparency for investment banks and hedge funds would also help.

The government and the market should try to deal with temptation. We hope that lenders will ask families to have done some saving in order to qualify to buy a home. Conscientious lenders could also nudge people to get off the refinancing merry-go-round, by suggesting that the term of the loan be shortened when a loan is refinanced. More ambitiously, private and public institutions could try to reintroduce an old social norm: try to pay off the mortgage sooner rather than later, and at the latest by the time you retire.

Greed and corruption helped create the crisis, but simple human frailty played a vital role. We will not be able to protect against future crises if we rail against greed and wrongdoers without looking in the mirror and understanding the potentially devastating effects of bounded rationality and limited self-control.

For earlier posts see here and here.

2 Responses to “Sunstein and Thaler on the origins of the financial crisis”

  1. richard Says:

    Bad underwriting was key to the financial collapse. Who pressured banks to make such loans?

    Many wanted to increase home ownership rates among minorities and low-income consumers. Carter and Clinton and W made big pushes and Fannie Mae Corporation eased credit requirements on loans that it bought from banks and other lenders.

    Fannie Mae faced increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people.

    Would anyone like to see why Franklin Raines donated so much money to Obama and became an advisor?

    In fact, during Jimmy Carter’s administration, Raines was a top official at the Office of Management and Budget (OMB) and also on the White House Domestic Policy Staff; later, he became Fannie Mae’s vice chairman in 1991 — then leapt back onto the White House staff in 1996, as Bill Clinton’s director of OMB.

    Anything about his jumps into and out of government under the Clinton administration.

    ”Fannie Mae has expanded home ownership for millions of families in the 1990’s by reducing down payment requirements,” said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer. ”Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.”

    Five years later, Raines was forced to accept “early retirement” for his accounting shenanigans, which put millions of dollars from Fannie Mae into his own pocket — as much as $90 million in extra compensation based upon overstated earnings. He later settled for a $3 million fine, which is actually paid by Fannie Mae’s insurance policy. So it goes in the Democratic era of Clinton; think “Sandy Berger.”

    The change in policy also comes at the same time that HUD [the Department of Housing and Urban Development] is investigating allegations of racial discrimination in the automated underwriting systems used by Fannie Mae and Freddie Mac to determine the credit-worthiness of credit applicants.

    Somehow I suspect that findings of “racial discrimination” directly bolstered congressional support for the Clinton policy that Fannie Mae (and Freddie Mac) scrap credit requirements in order to dramatically increase the number of mortgages extended to minority home buyers. As we have seen this year, it’s very hard to avoid flinching when the Left begins lobbing racism artillery shells; it’s the ammunition that never runs low.

    What an astonishing coincidence: An investigation by HUD into “racial discrimination” in credit ratings — probably based entirely on the “disparate impact” of such ratings on the ability of blacks and Hispanics to get home loans, rather than any comparison of default rates among whites, blacks, and Hispanics — followed immediately by deregulation that allows Fannie Mae to essentially ignore credit rating when it buys or guarantees mortgages, with the avowed purpose of increasing the rate of lending to minority home owners.

    In 1999, some warned: In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s.

  2. 2 de hypotheek Says:

    with reference to the reports of Richard Thaler and Cass Sunstein, it appear badly constructed economic model as the root cause of financial crisis. I agree, future catastrophies may be prevented with the new economic model, which is safe for common people and productive for investers. Ideal economic model to prevent future crisis may not be possible,however simplest possible model offers advantage to common people.

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