Cause of the Financial Crisis In One Word

"Too keen an eye for pattern will find it anywhere." ~ T.L. Fine

One need not be an expert in finance and economics to make some educated guesses as to what may be the root cause of this Financial Crisis.  Some words that come to mind might include greed, hubris, irresponsibility, complacency, and politics.

While each of these words certainly represents some level of culpability, please allow me to humbly sum up the cause of this credit crunch in one word... Heuristics.

What are heuristics?  I'm so glad you asked...

In psychology, heuristics describe how our brains are hard-wired to arrive at judgments, solve problems and make decisions, primarily based upon pattern recognition, especially when facing complex problems or incomplete information.

The use of heuristics has not changed in 100,000 years, and for the most part, neither has our human brain.  While pattern recognition may have worked well for pre-historic man to help him find food and avoid saber-toothed tigers, it does not always work so well for making financial decisions.

Now consider a simplified course of events as they relate to heuristics and the cause of this financial crisis:

• Banks, lenders, FNMA, FHMA, politicians and home buyers all assumed home prices would continue to rise indefinitely (because that was the recognized and socially accepted pattern) and based their respective policies and decisions on this assumption.

• As greed and complacency detected and intensified the heuristic hubris, the irresponsible practices of offering 100% loan-to-value (LTV)  to home buyers became common place -- even those with sketchy credit and capacity -- with increasingly risky loan types, such as "pay-option" adjustable rate mortgages (ARMs).

• Heuristics enabled home buyers to assume their personal incomes would increase in perpetuity; thereby justifying higher mortgage payments in the future when their pay option ARMS "reset."

• Greed and complacency also extended to exceedingly risky behavior on the part of large financial institutions -- all supported by heuristics, which also enabled the false safety net of Credit Default Swaps (CDS's).

Of course, we all know how this financial house of heuristics began to fall and the downward spiral that ensued.

"Continuing to cling to the patterns you know inhibits your ability to discover what you don't know." ~ Eric Allenbaugh

To give our primitive brain some credit, trends and patterns can be quite useful.... while they last.  The trend, however, is not always your friend; a coin toss landing on "heads" 7 times in a row still has only a 50% chance of landing on "tails" on the next toss; and just because you've never seen a saber-toothed tiger at your favorite watering hole, does not mean one won't show up tomorrow.

Similarly, if we do see a saber-toothed tiger at our favorite watering hole for several days, should we assume our ferocious foe will return for several more days to follow?

What about the most current "trend" of negative economic growth and falling stock prices?  Is the natural tendency now to assume the recession and bear market will continue as far as the mind's eye can see?  Is this assumption a mistake?  Why or why not?

Today, I'll end with the same quote as I began:

"Too keen an eye for pattern will find it anywhere." ~ T.L. Fine

--------------------------------------

Related Posts:

We Are All Naive Scientists
Know Thy Risk

Comments

[Penguin]

Well said! I think this is why success is almost always associated with independent thinking rather than herd mentality... It is always refreshing (and educational) to read your material. Hat tip.

[Kent @ The Financial Philosopher]

Thanks for the positive energy, Penguin!

Cheers...

Kent

[Editor]

Adam Smith employed heuristics to arrive at very relevant judgments about "overtrading." I enjoyed this February 10, 2009 essay on his thinking about asset bubbles:
Adam Smith gets the last laugh
http://www.ft.com/cms/s/0/2802e3a8-f77c-11dd-81f7-000077b07658.html?nclick_check=1

[Kent @ The Financial Philosopher]

Editor:

Thanks for the positive comment and for the interesting link.

Cheers...

[Peter]

Good post.One need not be an expert in finance and economics to make some educated guesses as to what may be the root cause of this Financial Crisis...
http://undiscoveredequities.com/

[Jordans Sneakers]

The sea can accommodate all, so we just to see the sea, our heart is infinitely more freedom and broad!

[Jeff from Silver Coast Finest]

i really found your blog much interesting than other blog sites, i just bookmark your blog :D have a nice day

[Chicago bankruptcy lawyer]

Many factors directly and indirectly caused the financial crisis.Major cause is a vulnerable or fragile financial system, including complex financial securities, a dependence on short-term funding markets, and international trade imbalances.