When American financiers were flogging subprime mortgages back in the credit boom, were they completely delusional? Or were they driven by cynicism and greed? Did they, in other words, know that the housing market was a bubble – or did they actually believe their own hype, even as the frenzy grew?
It is a question that armies of lawyers and prosecutors have asked in recent months, as the public flails around seeking a culprit to blame for the financial crisis. Unsurprisingly, many politicians and prosecutors have tended to err on the “greedy and cynical” side. With the benefit of hindsight it’s hard to imagine that any banker close to the mortgage market in 2006 could have failed to spot the excesses; or that anyone who was repackaging those loans into bonds – or “securitising” them, to use the industry jargon – did not spot the risks. Documents subpoenaed from the banks and credit rating agencies certainly show that some individuals felt uneasy – and (unwisely) expressed their concerns in colourful emails.
But last week three American economists at Princeton and Michigan issued some startling new research – and it should make us all pause for thought. For if you look at the personal financial decisions of the bankers involved in securitisation in that period – at the very heart of the credit bubble – it seems many believed their own hype. Many of them not only bought large quantities of housing stock at the worst possible moment (ie in 2005 and 2006), but also did so in some of the most “bubbly” markets, such as southern California. They then failed to sell those properties in time – and thus were left nursing losses after 2007. Or to put it another way, the bankers who were repackaging housing loans not only lived by the mortgage sword, but suffered under it too.
In some senses, this does not surprise me. Back in 2007 and 2008 I wrote a book about the financial crisis and spoke to many bankers who were involved in the securitisation game. And, on the basis of that anecdotal evidence, I concluded that most of the financiers who inflated that bubble were not crazy or evil (as popularly perceived) – but plagued by tunnel vision and groupthink.
But what is noteworthy – and fascinating – about the Princeton paper is that the research adds some tangible numbers to my hunch. To get those numbers, the three economists – Ing Haw Cheng, Sahil Raina and Wei Xiong – employed a combination of detective work, data mining and maths. They started by combing through the published lists of bankers who attended the 2006 American Securitisation Forum’s annual conference in Las Vegas and randomly selected 400 mid-level securitisation bankers from organisations such as Citigroup, Lehman Brothers and Wells Fargo. They then cross-referenced the names against publicly available data – extensive in the US – on subsequent real estate transactions and mortgages, and analysed whether those people had been trading properties, and whether they made or lost money.
Next, the three economists repeated a similar exercise for a randomly selected group of 400 lawyers and 400 Wall Street equity analysts who were not involved in housing analysis. The aim was to see whether patterns among those real estate transactions were unique to the housing experts – or just reflected something that all wealthy professionals tended to do.
The results were striking. Before conducting the research, the economists had expected that securitisation experts would be good at judging when to sell properties and how to avoid housing market losses; after all, they were close to the front line of the mortgage industry and supposed to know all about real estate. But in reality, the number-crunching showed “little evidence of securitisation agents’ awareness of a housing bubble and impending crash in their own home transactions”, as the paper says. The supposed experts “neither managed to time the market nor exhibited cautiousness in their home transactions”. Furthermore, they actually suffered bigger losses on housing than the random “control” group of lawyers who were not “experts” on housing at all.
Many FT readers might simply consider that divine justice. But there are wider implications. First, the results show (once again) that it is a mistake to devise economic theories on the basis of the “rational”, all-seeing man; cognitive biases and groupthink are crucial in explaining how markets work and overshoot. Second, the results also cast doubt on the wisdom of assuming that we can curb risky bank behaviour by simply demanding that bankers have “skin in the game” – that is, that they are investing in the same areas as those they encourage to. As the research shows, bankers can make bad decisions even when their own money is at stake. Or to put it another way, it is groupthink and wishful thinking – not deliberate malevolence – that poses the biggest risk in finance. And that will remain true long after we have forgotten those subprime sins. Investors – and bankers – should read this Princeton research, and stand warned.