Friday, January 28, 2011

How To Stop The Next Financial Crisis

Thursday, the Financial Crisis Inquiry Commission (FCIC) released its 633 page report on the causes of the financial crisis. But it took a Bloomberg article to finger the deeper cause of the latest financial crisis -- confirmation bias (CB) -- a common decision disease that leads the powerful to ignore data that's not consistent with the narrative they want to promote. To stop the next financial crisis, we need to create and fund an independent investigative process with a loud microphone.

The FCIC report points out, among its other findings about which I posted on Jan. 26, that regulators turned a blind eye to the problems in the housing finance system until it was too late. According to Bloomberg, Angelo Mozilo, who ran what had been America's largest mortgage lender, Countrywide, warned in Sept. 1, 2004 that reckless mortgage lending could "cause a bump in the road that could bring with it catastrophic consequences." But the Fed believed everything was fine -- as evidenced by a mid-2005 staff briefing arguing that the mortgage market had "solid fundamentals."

Mozilo's conclusion and the Fed's reaction reveal important insights into what went wrong. Mozilo's reaction to Countrywide's bad mortgages was not to stop making them but to get them off the company's books through securitization. The Fed was supposed to make sure that bad mortgages never got into the system in the first place, but instead it lapped up information suggesting that everything was fine.
Why was the Fed ignoring the subprime mortgage calamity brewing within its regulatory purview?  It was a clear cut case of CB. As Geoffrey Miller, director of New York University’s Center for the Study of Central Banks and Financial Institutions, told Bloomberg “What this shows is that the Fed had blinders on. They had some doubts about the market, but they chose to overlook them because they already had a view. They saw what they wanted to see.”

In order to understand how CB influenced the Fed, it is important to point out that the Fed Chair at the time, Alan Greenspan, had been a long-time proponent of financial deregulation. And he came by those beliefs through a long process of acculturation in the ideas of Ayn Rand. As a result, accepting the idea that deregulation could lead to catastrophe would force Greenspan to admit that his fundamental beliefs were wrong. As a result, Greenspan rejected the evidence of a crumbling mortgage securitization industry because it challenged those beliefs.

Fortunately, there are ways to fight CB. As I argued in my Autumn 2007 Business Strategy Review article, "When the Blind Lead," organizations that are good at fighting CB systematically seek out feedback from their customers to learn what's working and what's broken. And they also evaluate their people on a regular basis to reward the ones who are pushing for improvement and weed out the ones who block such positive change.

What does this have to do with stopping the next financial crisis? The ideal answer would be to put people in charge of our institutions who have a natural inclination to fight CB because they instinctively view it as a terrible threat to an organization's long-term survival. Unfortunately, our country tends to promote people into political roles based on how well they represent the talking points of the party in power. And this often means that in a face-off between ideology and reality, ideology will win.

This leaves us with the next best answer -- setting up an independent body of investigative journalists to seek out the weak signals of the next financial crisis before calamity strikes. Such investigators might be funded through an endowment from wealthy individuals who believe that a tireless search for the truth is a worthy cause in and of itself.  And these investigators ought to get access to very loud and pervasive means of getting their research findings out into the public discussion.

It's often said that generals are always fighting the last war. Similarly, financial regulators are now putting in place regulations that are intended -- with incomplete success -- to stop a recurrence of what caused the last financial crisis. Unfortunately, history shows that each financial crisis, including the crash that led to the Great Depression, the 1990's S&L crisis, the 1982 Less Developed Country (LDC) debt crisis, and the 1990's dot-com bubble whose bursting cost $5 trillion; has a different cause -- although many are precipitated by too much borrowing.

History also shows that there are always plenty of early warning signals of a crisis well before it happens. If we really want to stop the next financial crisis, we need to find a much better way to keep CB from drowning out those signals before it's too late to avert the next crisis. If we can't appoint leaders who fight CB on their own, we need to create muscular investigators who seek out the truth and amplify those weak signals while there's still time.


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