Looking Back at the Financial Crisis

The Role of Saturating Overconfidence
Blog Post
Sept. 13, 2013

It has been five years since the failure of Lehman Brothers and the beginning of the global financial crisis. Over this time, dozens of books have been written, thick Congressional reports have been issued, and even full-length documentaries have been filmed – all seeking to explain how the crisis happened.

For all of the forensic investigating, though, it still feels like we are characters in the classic tale about the six blind men and the elephant. One report blames Wall Street executives. Another singles out the regulators. Still others criticize the ratings agencies, the banking industry’s compensation practices, the Clinton and Bush Administrations, disreputable mortgage lenders, naïve mortgage borrowers, homebuilders, and appraisers. One London columnist even suggested that there was “simply too much money in the world.”

Given all of the time and money spent looking at the banking crisis, it is striking how little agreement there is today on the causes.

As someone who studies how changes in confidence alter our decisions and actions, l would offer that the big elephant in the room, which ties together all of the various suggested causes behind the banking crisis, is “saturating overconfidence.” Everyone – borrowers, lenders, builders, regulators, investors, political leaders – believed, or maybe I should say over-believed, in the strength of the housing market and the banking system. Heck, at the top, just before the crisis, Wall Street analysts even coined the term “Goldilocks Economy” to describe the “just right” business conditions they saw ahead as far as the eye could see.

Now I realize that saturating overconfidence may seem like a trite oversimplification of the root cause of the crisis, but there are some very important lessons that are revealed by looking at how confidence affects what we think and do, particularly at the extremes. I’d like to focus on three of those behaviors, particularly as these themes are still frequently raised as criticisms of the banking industry today.

Confidence and Our Perception of Certainty

While economists and psychologists continue to debate the chicken-or-the-egg nature of the relationship between confidence and our perceptions of certainty, what is clear is that when we are confident we perceive the world around us to be safe. This holds true whether that world is a football field for a quarterback, the South Pacific for a sailor, or the housing market for Americans in 2005. High confidence equals high trust.

confidence graph

Admittedly, for the housing market, the extreme confidence and trust was built over a very long period of time. But note how over the seventy years since the Great Depression our views of housing changed from homes simply as shelter, to homes as a key milestone in our achievement of the American Dream, to homes as a surefire investment. What we believed to be true reflected higher and higher levels of confidence.

There is a funny thing about confidence, though. While we may say that we are confident today, what we are really expressing is our confidence in the future. Confidence is entirely forward-looking. It is our belief in how we will fare ahead. For homebuyers, mortgage lenders, the rating agencies, financial regulators, and even the producers of television shows like “Flip That House,” the decisions they made at the peak were all extrapolations into the future of the belief system that derived from years of positive experiences. Just imagine how certain mortgage lenders had to be to make thirty-year loans at the top of the market to “no income, no job” (“NINJA”) borrowers!

At the peak of the housing market not only were the beliefs certain, but everyone shared those same beliefs. Home prices would continue to go up in value forever.

Confidence and Complexity

At their core, companies are in the business of growing confidence. Rising confidence means the ability to offer more products and services to more customers in more places than ever before. Few businesses offer a clearer picture of this than the financial services industry from the Great Depression to 2007. At the peak in confidence six years ago, financial services firms and their customers and regulators believed that banks were able to offer every possible product – from lending to insurance and investment management and brokerage – to every possible customer (business, consumer and government) everywhere in the world.

confidence graph

What few appreciated at the time, however, was the true underlying extreme complexity that existed within these organizations at the peak. Through mergers, global expansion and product line growth, the internal operations for most banks resembled an oversized computer chip. Even more, thanks to industry-wide high confidence in the late 1980’s and 1990’s, financial services firms had added innovative products and services, including securitization, interest rate swaps and credit derivatives on top of their already high organizational complexity.

But there are two additional aspects of confidence-driven complexity which banks also exhibited at the peak: extreme interconnectivity and agency.

Concurrent with the peak in US confidence, there was unprecedented global confidence. For financial services firms, the resulting free mobility of liquidity and capital before the banking crisis was assumed to be a permanent condition. When coupled with the explosive growth in over-the-counter derivatives, the result was an unmatched intricate web of financial flows among banks, governments and central banks. Large financial services firms were simultaneously creditors, counterparties, clearing agents and debtors in ways few grasped.

Finally, at the peak in confidence, there was a proliferation of third-party agents. From independent mortgage originators, home appraisers, and trustees to Standard & Poor’s and Moody’s and asset management firms, the financial system had subcontracted and outsourced traditionally in-house capabilities to what they believed to be trustworthy partners.

To get a sense for what the peak in confidence-driven complexity – with its extraordinary associated interconnectivity and agency – looked like in the financial services industry just before the crisis, one need only look at this image which Daniel Edstrom of DTC Systems created to diagram what happened to his own home mortgage after it was originated.

confidence graph

That the aftermath of the housing crisis has uncovered unprecedented fraud and generated more than $100 billion in legal settlements is hardly a surprise given that there are millions of other mortgages with similarly complex flow charts out there involving hundreds of thousands of different agents and third parties.

Confidence and Skepticism

While unprecedented trust and complexity contributed to the banking crisis, there was a third important confidence-driven element that helped to create the perfect storm: skepticism, or more accurately, the complete lack thereof.

confidence graph

Skepticism and confidence are inversely correlated, and as a result scrutiny and risk management decline as our confidence grows. And it is not just within businesses where this takes place. High public confidence consistently results in deregulation. In 1999, with the Dow climbing above 11,000 for the first time and Internet stocks soaring in value, Congress (aided by banking regulators) repealed the Glass-Steagall Act, believing that the separation of banks and brokerages mandated after the 1929 Stock Market Crash was no longer necessary.

When everyone finally believed that the tightrope walker could move blindfolded across the high wire, the regulators took away the nets. High confidence eliminated the need for strong regulation.

To be fair, the lack of skepticism went well beyond Washington. No one was looking. In the five years since the collapse of Lehman Brothers we have seen plenty of examples in which scrutiny was lacking. From Bernie Madoff to Lehman Brothers itself the standard risk management procedure might best have been described as “don’t ask, don’t tell.”

When trust is high, there is no need to ask questions.

Needless to say, the financial services industry’s extreme complexity coupled with a saturating belief in the investment value of American housing and lax, if not entirely missing, scrutiny and oversight set the stage for the banking crisis.

confidence graph

But this same extreme overconfidence also contributed to the speed and severity of panic. Confidence is like a LEGO tower. It takes a long time to build, but it can be destroyed very quickly.

What was destroyed in 2008 was confidence built over almost eighty years. The tower was extremely tall – built over a long period of time by an extraordinarily large number of people. At the top even the most strident “Doubting Thomases” had joined in. We all believed.

While confidence has improved since its bottom in 2009, it is fascinating to see how the issues of “trust”, “complexity” and “skepticism” continue to swirl around the banking industry. Thanks to our continued “malaise” in confidence – despite the recovery, economic confidence still remains negative – we want a financial system that is simpler and more highly regulated.

Should our confidence improve from here, the concerns about the safety and soundness of the banking system will diminish. On the other hand, should confidence fall, the break-up and global “retrenchment” of our largest banks is all but certain, as this generation’s version of Glass-Steagall is enacted. Washington always reflects American voter confidence.

Changes in our level of confidence change what we believe to be true and in turn our decisions and actions. Before the banking crisis, we believed that the sky was the limit for housing and banking. Even more we all acted like it. Saturating overconfidence – with its naturally high trust and complexity as well as low scrutiny – was the elephant in the room that we missed.

Too bad that after five years it still feels like we are walking around with our blindfolds on.

Peter W. Atwater is a member of the World Economic Roundtable and the president of Financial Insyghts LLC. The author of “Moods and Markets” (FT Press), Peter writes and speaks frequently on socionomics and confidence-driven decision making.