Thursday, September 2, 2010

Systematic thinking WAS THE PROBLEM in the mortgage crisis . . . ignoring the idiosyncratic warning signs of impending disaster

This blog focuses on applying organizational behavior and leadership concepts to current events. Last year, I focused attention on the financial meltdown of 2008 and its aftermath. It makes sense to carry the financial crisis theme into the first blog of this semester before moving on to other issues. One area of interest for me as a researcher and observe of events is how learning breaks down in organizations and the consequences of these break downs for organizational viability.

Evidence that learning is breaking down takes several forms. One form of evidence can be found when an individual in a powerful position recognizes a challenge to conventional wisdom, but writes it off as anecdotal because he cannot find systematic evidence of a trend.

While many write off anecdotes as untrustworthy information, an anecdote often provides an early warning sign of impending disaster.

An example of failing to take seriously anecdotal information occurred prior to the subprime mortgage meltdown when regulators noticed homeowners began to default on their mortgages, but failed to see systematic trends and therefore took no action. An interview with US Federal Reserve Chairman Alan Greenspan on CNBC highlights the problem.

Click here for a link to a section of the interview in the CNBC documentary House of Cards

http://www.cnbc.com/id/15840232?video=1029053619&play=1

(Unfortunately, the section where Greenspan discusses how and why he discounted early warning signs as ‘anecdotal’ is only the DVD that must be purchased.

The reason that regulators such as Greenspan ignored the data was because of a fundamental disbelief in the nature of anecdotal data. Greenspan, by his own admission, ignored early warning signs of the subprime meltdown because the signs were simply stories, one time events, even willy-nilly Yet, by the time the meltdown went into full force, subprime accounted for as much as 20 % of the entire mortgages in the country. The stories proved more than anecdotes, they were in fact representative of a larger situation.

To understand the problem that results from valuing systematic trends over anecdote is to understand why organizations often overlook early warning signs of disaster. Systematic evidence of impending disaster is just as likely to displays itself in a story, personal accounts, even sketchy evidence, as it is to display itself in systematic evidence such as statistics or trends.

Systematic evidence of problems often occurs too late in the cycle of disaster to be of much good to ward off the crisis. Some have even referred to reliance on non-systematic data as a biases that limits decision making. See Max Bazerman’s wonderful text on this topic, Judgment in Managerial Decision Making.

But the failure to heed antidotal or seemingly idiosyncratic data is not as rational as some may lead us to believe. In fact, failure to heed early warning signs is itself a bias, ignoring certain data at the expense of other data (what sociologists refer to as cognitive ‘editing’) is a skill, something developed over time – a quality of judgment. In many ways, those in the storm of the financial crisis ignored the behavioral or psychological side, they wrote off the use of judgment as irrational, when in fact they are simply embracing their own form of bias . . . which seems to have been a pandemic of bias during the financial crisis.

A recent documentary by the group at Frontline entitled The Warning

http://www.pbs.org/wgbh/pages/frontline/warning/

exposes some of the oddities of Greenspan’s thinking. For example, did you know his philosophy on free-markets with little or no government regulation, his so-called ‘laissez-faire’ approach, is based on a philosophy put forth by cold war novelist Ayn Rand? Rand wrote novels such as Atlas Shrugged a favorite of corporate titans that supports only the use of strict rational logic in business and economics.

By his own admission, the principles to which he had clung, and which dominated US economic policy for almost two decades was not a systematic philosophy that describes how the world really works, but rather a system of belief about how things ‘should work’. I am not necessarily saying that the ideas of ‘objectivism’ the philosophy of Ayn Rand isn’t without merit, every young capitalist, including myself goes through a phase of admiring the objectivist world view. But then we must grow up, and come to terms with the idea that laissez-faire is really characterized by lazy thinking.

The financial crisis that came to a climax in 2008 revealed several important insights into the psychology of learning from failure. Assumptions about the nature financial markets and how they works, personal investment in prior success, organizational tendency to downplay failure and over emphasize success result not simply from systematic bias, but rather from efforts to maintain ‘alleged’ systematic thinking at the expense of good judgment. In the end, learning broke down.

How is a great leader to assess these warning signs and separate the representative anecdote from the non-representative one. The first is to hold your biases loosely and be open to challenges. Had Greenspan and those like him been smart enough to recognize the limits of ‘objectivism’ and embraced the subjective, we might all be in better shape today.

7 comments:

Krishnan Sankaranarayanan said...

Very thought provoking blog. I would like to add the following comments. It seems to me that Greenspan was essentially falling into a confirmation bias trap, and was ignoring perhaps unknowingly those pieces of information that were disproving his dominant hypothesis. This was recently discussed in an HBR audiocast (I can't seem to remember the exact reference though) and in Bazerman.
One could also wonder, whether the mental resistance to leaving the status quo, played a role.
In any case, it highlights that highly intelligent people like Greenspan are not picking up on the early warning signs, and are failing to learn. It does bring me to an interesting point/question. In class, you mentioned that in the new knowledge economy, those with knowledge will be the best leaders, rather than those whose motives/drivers are power/influence/relationship etc. I think, unless I misunderstood the statement, the statement a corrolary to the statement could be "knowledge or expert leaders, who continue to learn". The reason I think this needs to be there, is that experts fall into the trap of confirmation bias and overconfidence (how often to experts agree anyway?!) but only those with an open mind can really lead and perhaps see how the rules of the game are changing.
An interesting tangent I would like to bring to this discussion is the field of "Abnormal event detection". Though very mathematical in nature, the essence is that events occur in a certain way (the normal way) with some variance, and that every now and then there is an anomaly, which cannot be explained by usual methods of analysis. It is caused by something fundamentally different, and is caused by a strange event, or perhaps changing of the game.
In this case, the game of finance involves people, and in economic theory, one of the basic assumptions is that the people try to maximimze their utility function, satisfaction, consumption (or something like that), but basically behave rationally, and independent. This usually works out well, but events such as panic in the market can never be explained by this, as people will start selling when others are selling (how is this rational, if you bought high?!). Rationality of the markets, or irrational exhuberance (hasn't something like this happened before with the overvaluing of the tulips and subsequent crash in 1637 and many times after?), the fact is we need to be cautious and more importantly, learn continuously.

Krishnan Sankaranarayanan said...

Very thought provoking blog. I would like to add the following comments. It seems to me that Greenspan was essentially falling into a confirmation bias trap, and was ignoring perhaps unknowingly those pieces of information that were disproving his dominant hypothesis. This was recently discussed in an HBR audiocast (I can't seem to remember the exact reference though) and in Bazerman.
One could also wonder, whether the mental resistance to leaving the status quo, played a role.
In any case, it highlights that highly intelligent people like Greenspan are not picking up on the early warning signs, and are failing to learn. It does bring me to an interesting point/question. In class, you mentioned that in the new knowledge economy, those with knowledge will be the best leaders, rather than those whose motives/drivers are power/influence/relationship etc. I think, unless I misunderstood the statement, the statement a corrolary to the statement could be "knowledge or expert leaders, who continue to learn". The reason I think this needs to be there, is that experts fall into the trap of confirmation bias and overconfidence (how often to experts agree anyway?!) but only those with an open mind can really lead and perhaps see how the rules of the game are changing.
An interesting tangent I would like to bring to this discussion is the field of "Abnormal event detection". Though very mathematical in nature, the essence is that events occur in a certain way (the normal way) with some variance, and that every now and then there is an anomaly, which cannot be explained by usual methods of analysis. It is caused by something fundamentally different, and is caused by a strange event, or perhaps changing of the game.
In this case, the game of finance involves people, and in economic theory, one of the basic assumptions is that the people try to maximimze their utility function, satisfaction, consumption (or something like that), but basically behave rationally, and independent. This usually works out well, but events such as panic in the market can never be explained by this, as people will start selling when others are selling (how is this rational, if you bought high?!). Rationality of the markets, or irrational exhuberance (hasn't something like this happened before with the overvaluing of the tulips and subsequent crash in 1637 and many times after?), the fact is we need to be cautious and more importantly, learn continuously.

Krishnan Sankaranarayanan said...

Very thought provoking blog. I would like to add the following comments. It seems to me that Greenspan was essentially falling into a confirmation bias trap, and was ignoring perhaps unknowingly those pieces of information that were disproving his dominant hypothesis. This was recently discussed in an HBR audiocast (I can't seem to remember the exact reference though) and in Bazerman.
One could also wonder, whether the mental resistance to leaving the status quo, played a role.
In any case, it highlights that highly intelligent people like Greenspan are not picking up on the early warning signs, and are failing to learn. It does bring me to an interesting point/question. In class, you mentioned that in the new knowledge economy, those with knowledge will be the best leaders, rather than those whose motives/drivers are power/influence/relationship etc. I think, unless I misunderstood the statement, the statement a corrolary to the statement could be "knowledge or expert leaders, who continue to learn". The reason I think this needs to be there, is that experts fall into the trap of confirmation bias and overconfidence (how often to experts agree anyway?!) but only those with an open mind can really lead and perhaps see how the rules of the game are changing.
An interesting tangent I would like to bring to this discussion is the field of "Abnormal event detection". Though very mathematical in nature, the essence is that events occur in a certain way (the normal way) with some variance, and that every now and then there is an anomaly, which cannot be explained by usual methods of analysis. It is caused by something fundamentally different, and is caused by a strange event, or perhaps changing of the game.
In this case, the game of finance involves people, and in economic theory, one of the basic assumptions is that the people try to maximimze their utility function, satisfaction, consumption (or something like that), but basically behave rationally, and independent. This usually works out well, but events such as panic in the market can never be explained by this, as people will start selling when others are selling (how is this rational, if you bought high?!). Rationality of the markets, or irrational exhuberance (hasn't something like this happened before with the overvaluing of the tulips and subsequent crash in 1637 and many times after?), the fact is we need to be cautious and more importantly, learn continuously.

Harrison said...

I find this very relevant to what I've been experiencing in work recently. I'm by nature a pretty systematic thinker. I quickly dismiss new information unless I see a clear trend. I'm surrounded by people who are not as systematic. They allow feedback from a single source to drive conversation and strategy. What's interesting, though, is that if I were to wait for a true trend to emerge, I would already be almost powerless to respond to it. I'm learning to value the observations of people, even if it doesn't represent a clear trend. I may never be able pick up on stuff and respond to it the same way others do, but I can surround myself with enough people who do that I'm forced into forward-thinking and motivated to change. Perhaps Greenspan didn't have anyone around him that he trusted that had an ear to the ground picking up on trends that were yet to emerge...maybe there wasn't enough free-thinking going on in his office. I know that without being surrounded by people not like me, I wouldn't have seen half the potential problems coming my way.

jason said...

I know that we were taught at a young age to learn from history and triggering mechanisms have been put in place by regulators to prevent another mortgage crisis event to occur anytime soon, but if it's not one thing to slow a growing economy then it will be another. Despite Greenspan and his unwillingness to pay attention to the economic indicators that demanded change, I have to entertain the idea that he may have been smart enough to at least sense such difficulties ahead, but perhaps didn't want to be the one to sour the party or perhaps was blinded by the successes surrounding him. When looking at leadership it is important that we are willing to step outside of our comfort zone and be strong enough to turn the lights out on a good time, even if it means being considered the bad guy. Did Greenspan just not have the courage to do so and is he now looking back and wondering what if?

A leader needs to stand behind all decisions and in the end regardless of the outcome be prepared to take full acceptance of responsibility as Greenspan has. Perhaps pressures from the outside guided Greenspan into thinking things were fine and to ride it out using the wait and see approach. Greenspan is the fall guy of the most recent recession, but what are the leaders of the World doing to prevent the next or even avoid the potential “double dip” recession? Is the next bubble to burst in China and how will the United States ever recover from the US National Debt, Social Security funding shortfalls and everything else that exists? I wonder if it ever ends. If we learn from history, how is it that we continue to keep falling into such traps and which leader today can look at Greenspan and history and perhaps make a change?

Krishnan Sankaranarayanan said...

To build on what Harrison and Jason said, I think we are always fighting the last battle. Think about the precautions now put in place in the financial industry or lending. All the checks and balances are a response to something that had happened earlier, and are meant to prevent something similar from happening in future. Similarly, the increased safety regulations when flying are meant to prevent tragedies which should never have occurred. But, they are all assuming that the next thing will be similar. So, in a sense we are learning, but perhaps in a single loop fashion (Argyris and Schon, 1978). Even double loop learning, which should try to question the basic premises that lead to the single loop response etc, may be inadequate. Higher order learning is probably required, but difficult. We generally do not do to well at recognizing analogies with other fields and applying them.

We evolve (or are forced to) as the environment is changing, and we learn in single and double loop. However, once the environment changes to quickly, these learning approaches are insufficient.


It is easy to ascertain that a train has derailed after it is found off the tracks, but when you're leaving the station do you really know where you're going?

Neeru said...

In response to Krishnan's question: In the aftermath (hoping it is almost over) of this financial crisis, people need to wake up and with open eyes know where they are going. We blame the leaders of the mortgage companies (ignorance, wanting to make a profit based on a bubble), but in truth, everyone is to blame. Americans did not plan for the future and the concept of savings was ignored. When I bought my first house in 2006, I planned (not only for the interium, but for the next five years), saved for a 20% down payment and put my family on a budget. This is the only way I was taught to do it. Those who are facing foreclosures are blaming the leaders of Wall Street, but one must know their own strengths/weaknesses before taking any action, as you have to face up to the reactions/outcomes from your decisions.
People were joining the mortgage bandwagon (easy way to make a buck), without understanding the risks involved with such a large investment. I believe, many were picking up the early signs of failure, but chose to ignore it, one, because it was the popular thing to do and two, they were not taking ethics into consideration. As leaders we need to be able to step aside from the common group and express decisions/thoughts that are not well-accepted by the popular group.