Location: New York
Author: Ira Artman
Date: Wednesday, March 4, 2009

*  If one person, just one person, does it - they may think he's really sick...
* And if two people, two people do it, in harmony, they may think they’re both [strange]...
* And three people do it, three, can you imagine, three people ... [doing it], they may think it's an organization.
* And can you, can you imagine fifty people ... doing it? They may think it’s a movement.

Source: Arlo Guthrie, Alice’s Restaurant, 1967.

Arlo Guthrie was wrong. Millions of us did it – paid too much for our homes, that is. Now, it all seems strange and we all feel quite sick. But why?

Perhaps, suggests Princeton behavioral economist Roland Bénabou, it was because of the way the housing boom rewarded those who believed and punished those who did not.
MUTUALLY ASSURED DELUSION

Bénabou describes a model of collective reality denial, or groupthink, that he calls Mutually Assured Delusion:

* Whenever an agent benefits from others’ delusions, the agent becomes more of a realist; and
* Whenever an agent is harmed by others’ delusions, the agent denies or attempts to overlook the others’ delusions.

Roland Bénabou, Groupthink: Collective Delusions in Organizations and Markets, March 2009

Enterprises most prone to collective delusions include:

* Those involving new products or markets with a highly attractive upside and a disastrous downside; and/or
* Those in which participants have limited exit options, with outcomes very reliant upon the wisdom or foolishness of others.

These include, Professor Bénabou suggests:

* Enron employees, who had 58% of their pension portfolios invested in company stock; and
* Bear Stearns employees, who held 30% of Bear stock “until the last day... [when they] lost their capital together with their jobs.”

PATTERNS OF DENIAL

Professor Bénabou concludes by providing numerous examples of organizational failures and market meltdowns - many from the current financial crisis. Below are just a few.
Preposterous Probabilities

* “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

Joseph Cassano, AIG Financial Services, Aug 2007; in G. Morgenson, The New York Times - Behind Insurer’s Crisis, Blind Eye to a Web of Risk, 28 Sep 2008.

Information Avoidance

* “Between 2005 and 2007, [Fannie Mae’s]... acquisitions of mortgages with down payments of less than 10% almost tripled... For two years, [Fannie CEO Daniel] Mudd operated without a permanent chief risk officer [“CRO”] to guard against unhealthy hazards.
* When ... that position [was filled] in 2006, the CRO told Mr. Mudd that the company should be charging more to handle risky loans.
* In the following months... [the CRO] warned that some markets were becoming overheated and argued that a housing bubble had formed... But many of the warnings were rebuffed... [The CRO] was among those whom Mr. Mudd forced out of the company during a reorganization in August.”

C. Duhig, The New York Times - Pressured To Take More Risks, Fannie Reached The Tipping Point, 5 Oct 2008.

Overriding Alarms

* Federal Reserve governor [Edward Gramlich]... warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.
* But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed...
* Fed officials repeatedly dismissed warnings about a speculative bubble in housing prices... The Fed was hardly alone in not pressing to clean up the mortgage industry.
* When states ... started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Morgenson & Fabrikant, The New York Times - Countrywide’s Chief Salesman and Defender, 11 Nov 2007.

FORGETTING HISTORY

* Our market system depends critically on trust - trust in the word of our colleagues and trust in the word of those with whom we do business.
* Falsification and fraud are highly destructive to free-market capitalism and, more broadly, to the underpinnings of our society.
* In the latter part of the 1990s ... an infectious greed seemed to grip much of our business community... The trouble, unfortunately, is that the shock of what has happened will keep malfeasance down for a while.
* But human nature being what it is —and memories fade— it will be back. And it is important that at that time appropriate legislation be in place to inhibit activities that we would perceive to be inappropriate.

Alan Greenspan, Testimony before the Senate Committee on Banking, Housing, and Urban Affairs, 16 Jul 2002.

REFERENCES