...Giant Pool of Money In this radio story about the events leading up to the subprime mortgage crisis, it’s clearly demonstrated that a few psychological biases and heuristics were present and played important roles in forming the crisis. The most critical ones I’ve identified are the confirmation bias and the social proof phenomenon in the development of the crisis. Confirmation Bias Mainly two types of confirmation bias were observed in the subprime crisis: the confirmation trap as well as anchoring heuristics. Anchoring caused the banks to miscalculate real risks of the mortgages and related MBS/CDO, while the confirmation trap caused most people in the industry to ignore potential risks and keep playing the dangerous game. Bazerman and Moore defined the anchoring heuristic as “Individuals make estimates for values based on an initial value (derived from past events…), and typically make insufficient adjustments from that anchor when establishing a final value.” And the Wall Street banks made exactly this mistake leading up to the mortgage crisis. When estimating the default rate for subprime mortgage products, Wall Street banks used historical data which indicated an average default rate of 2%, then extrapolated to estimate the absolute worst-case scenario to be at worst 10% to 12%. However, such anchoring is misleading because most of the data were years old were based on loans with strict income, asset and credit requirements. On the contrary, the subprime loans on which...
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...The Giant Pool of Money 1) Drawing on what you learned in Session 1 and the readings that are assigned for Session 2, identify two psychological processes or biases exemplified by the individuals in the radio story that contributed to the subprime mortgage crisis. (At least one of the two processes that you write about should be taken from the Bazerman and Moore reading from Session 1. 2) Ignoring the actual regulatory context of the industry, design an institutional repair that might help prevent one of the processes you identified in part 1. The mortgage crisis triggered a severe global economic recession in 2008. It resulted in the collapse of the housing market, failure of key businesses, and a decline in consumer wealth. The crisis was caused because of the widespread use of financial products such as Mortgage-backed securities (MBS) and Collateralized Debt Obligations (CDO) without accurate evaluation of the risk of the underlying mortgages they represented. As the “Giant Pool of Money” shows, one major bias exemplified by the individuals was “confirmation trap”. Credit rating agencies rated MBS as “AAA” implying they were as safe as US Treasury Bonds which were the traditional investment choice of the global pool of money. The data used for this rating was based on relatively recent history of mortgages with low foreclosure rates. However this data did not apply to the new kinds of mortgages that were being issued. [1] The use of irrelevant data caused credit...
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...The Giant Pool of Money Analysis The housing crisis that occurred less than a decade ago is a great example, and has become an extensively covered case study, of how dangerous certain biases and heuristics can become if left unchecked on a massive scale. Alex Blumberg and Adam Davidson, in collaboration with NPR News, put together a special program titled “The Giant Pool of Money,” where they explore just how the phenomenon occurred and the underlying factors that contributed through sound bites of those directly involved, affected, or simply aware of the situation as it unfolded. Based on descriptions of various biases and heuristics in Judgment in Managerial Decision Making (Bazerman, 2009), the two biases that prolonged and strengthened the housing crisis in a significant manner can be seen in the “Ease of recall” bias stemming from the “Availability Heuristic,” as well as the “Anchoring” bias coming from the “Confirmation Heuristic.” Bazerman and Moore define the “ease of recall” bias as one where “individuals judge events that are more easily recalled from memory, based on vividness or recency, to be more numerous than events of equal frequency whose instances are less easily recalled.” The housing market and real estate had been doing quite well since the “Dot-com” boom and bust had rattled markets in the late 1990’s. Housing prices were continually increasing, and “lots of people in the mortgage industry had this faith that housing prices in the US simply never go down...
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...The Giant Pool of Money The individuals in the radio story fell prey to the confirmation bias/heuristic and availability bias/heuristic. The confirmation bias refers to “The tendency to search for or interpret information in a way that confirms Preconceptions”. The giant pool of money, which refers the subset of global savings allocated for fixed income securities, amounted to $70 trillion in 2006. In this case, the central banker held fed interest rate to a low level of 1%. The global army of investment managers, who managed the $70 trillion giant pool of money, wanted a low-risk high-return investment as the US treasury bonds didn’t look attractive at 1% interest. These investment managers invested in mortgage backed-securities (MBS) via big investment firms at Wall Street. Mike Francis, executive director at Morgan Stanley on the residential mortgage trading desk, sold financial instrument MBS to the global pool of money. To meet the high demands of global pool of money for MBS, Mike Francis needed to buy as many mortgages as possible to make MBS. Mike bought mortgages from mortgage banks and repacked them to MBS. People like Mike Francis were link to the global of money. Mike Garner, an employee at Silver State Mortgage, the largest private mortgage bank in Nevada, bought the individual mortgages and bundled 200 or 300 of them together, and then sold them up the chain to Wall Street investment banks, to guys like Mike Francis. The pool of money demand for these bundled...
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...Prologue. Ira Glass So Adam, where are we? Adam Davidson I recorded this at the Ritz Carlton in Lower Manhattan. It's a black tie dinner. It was just a few weeks ago. Ira Glass And you, by the way, are NPR's international business and economics correspondent? Adam Davidson That's right. I was there for my job. They're giving out awards for all these financial securities, including the one that nearly brought down the global financial system in the whole sub-prime mortgage crisis. Dinner Mc At this time, I'd like to ask all of our stars to please assemble over here on the left side of the stage-- Jim Finkel This guy is a legend. He's a granddaddy of our industry. Adam Davidson I'm sitting at this dinner with Jim Finkel. He's kind of nervous, because he's up for CDO of the year for the CDO he created, Monterey. Now, the CDO, that's what we're talking about. That's the financial instrument that was central to this global credit crisis we're in. Ira Glass And they gave awards for this? These guys are giving each other awards for doing that? Adam Davidson Let me just say that they were aware that there's a certain irony, giving awards to the instrument that almost destroyed the world economy. And they did consider canceling this year. But it's been a really tough year. It's been really gloomy for them. Jim Finkel Honestly, I know this sounds-- I was really happy to see there were no major suicides, people weren't jumping off bridges, there weren't a lot of personal...
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...The Issues The radio program draws an overall picture of the subprime mortgage crisis, how the subprime market was created, how the crisis happened, what were the result and its impact. (See appendix A - my summary of the case) The primary issues in this case are: why did the Wall Street bankers blindly trust that the risky mortgages were good assets to invest into? And why did everyone involved allow the whole thing to go this far? The Analysis The Wall Street bankers ignored the fact that the mortgages were risky is mainly due to the confirmation bias, specifically, the Anchoring Heuristic. Bazerman and Moore’s (2009) defines the Anchoring Heuristic as “Individuals make estimates for values based upon an initial value (derived from past events, random assignment, or whatever information is available) and typically make insufficient adjustments from that anchor when establishing a final value”. It was exactly what Mike Francis did when he made the decision to invest in the mortgages-backed securities. Facing the pressure to find new types of investment for the investors, he looked into the historical data of mortgages, and concluded that because the no income loans existed so far performed well, they would not have much risk in the future. His reasoning was flawed. The historical data set him the wrong perception and it anchored in his mind. Bazerman and Moore further argue that people tend to think that the subsequent information is in consistency with the preexisted anchor...
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...Bankruptcy of a Retail Giant Blunders by former Chairman Charles Conaway and President Mark Schwartz led Kmart into bankruptcy. The retailer had to close 284 stores, including this one in Novi, and lay off 22,000 workers. They lived the good life of gated estates, a 47-foot yacht, corporate jets at their beck and call, and multiple pay hikes, perks, bonuses and loans. But even as Kmart Corp. struggled for survival, its chairman, Charles Conaway, and president, Mark Schwartz, wanted more, renegotiating employment contracts that would ultimately net them a combined $34 million in less than two years. Conaway and Schwartz, the leaders of the $37-billion-a-year retail giant that lost $3.9 billion in its past five quarters and laid off 22,000 workers this year, were the central figures in the company's demise. Their management blunders led Kmart into bankruptcy, and questions abound as to whether they hid the company's financial condition from its board of directors, employees and shareholders. But one thing is clear: As Kmart spiraled downward, Conaway and Schwartz grew richer. With Kmart mired in bankruptcy, the payouts to Conaway and Schwartz came under scrutiny in a federal criminal investigation of accounting practices. Federal investigators zeroed in on the personal finances and compensation deals struck by Conaway, Schwartz and other former Kmart executives in the months leading up to the company's Jan. 22 bankruptcy filing in Chicago. The Kmart investigation...
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...Giant Pool of Money Analysis The awful subprime lending crisis is truly one of the most convoluted, wreaking messes conjured by the financial industries in the 20th century. There are so many layers of bad choices and megalomaniacal errors intertwined into this ugly event that picking out just two biases/heuristics to analyze and discuss will surely fail from being a complete analysis. Nonetheless, this is a the task at hand and, though we will not but scratch the surface of this behemoth, teasing out a couple biases will make for a viable illustration and application of the concepts and issues we have discussed thus far in class. The bias that caused the most havoc in this lending crisis scenario was articulated beautifully by Bazarman and Moore as The Confirmation Trap. The Confirmation Trap boils down to whether or not a person merely searches for data that supports the decision they wish to make rather than looking for proper, empirical data to prove the assumption correct. In other words, does a person looking to make a decision actually look to prove their assumption incorrect. Sadly, at nearly every stage and at every level of the subprime lending fiasco there is evidence that all the players fell victim to The Confirmation Trap. Wason writes, “ . . . that obtaining the correct solution necessitates a willingness to attempt to falsify hypotheses, and thus to test those intuitive ideas which so often carry the feeling of certitude.” None of the characters in our...
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...European Crisis From late 2009, fears of a sovereign debt crisis developed among investors concerning rising government debt levels across the globe together with a wave of downgrading of government debt of certain European states. Concerns intensified early 2010 and thereafter[3][4] making it difficult or impossible for Greece, Ireland and Portugal to re-finance their debts. On 9 May 2010, Europe's Finance Ministers approved a rescue package worth €750 billion aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF).[5] In October 2011 eurozone leaders agreed on another package of measures designed to prevent the collapse of member economies. This included an agreement with banks to accept a 50% write-off of Greek debt owed to private creditors,[6][7] increasing the EFSF to about €1 trillion, and requiring European banks to achieve 9% capitalisation.[8] To restore confidence in Europe, EU leaders also suggested to create a common fiscal union across the eurozone with strict and enforceable rules embedded in the EU treaties.[9][10] While the sovereign debt increases have been most pronounced in only a few eurozone countries, they have become a perceived problem for the area as a whole.[11] Nevertheless, the European currency has remained stable.[12] As of mid-November 2011 it was trading even slightly higher against the Euro bloc's major trading partners than at the beginning of the crisis.[13][14] The three most affected...
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...hypothermia. The body found naked, draped across the body of a giant whale. He got passed security and still remained in SeaWorld after it closed. Then jumped, fell, or was pulled into the pool and died. Any people could potentially die from one of these animals. The whale could hurt, or even kill you. Since the whales and dolphins are in captivity the more likely the animals are to catch a disease that is spread by humans that could be deadly to the animal. Orcas are given up to 80 pounds of gelatin to fight dehydration. Gelatin isn’t always the best way to hydrate an animal, that could hurt the health of an orca. Collapsed dorsal fins show that an orca is unhealthy, this collapsing of the dorsal fin rarely happens in the...
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...Experience The Fremont Street Experience is the next big thing in Las Vegas entertainment. The experience is a giant open air mall in the heart of the Old Las Vegas Strip. The Experience encompasses old Fremont street and has casinos and other amazing attractions. When you’ve run out of money, you can find many free attractions to experience at the Experience. For instance: • Get your picture taken with Vegas Vic or Vegas Vickie, the iconic Vegas Cowboy and Cowgirl of Glitter Gulch! • Take the Banger Brewery Tour –...
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...off them for 10 seconds and guaranteed, they'll be into some shit again: This bank is like the world's worst-behaved teenager, taking your car and running over kittens and fire hydrants on the way to Vegas for the weekend, maxing out your credit cards in the three days you spend at your aunt's funeral. They're out of control, yet they'll never do time or go out of business, because the government remains creepily committed to their survival, like overindulgent parents who refuse to believe their 40-year-old live-at-home son could possibly be responsible for those dead hookers in the backyard. It's been four years since the government, in the name of preventing a depression, saved this megabank from ruin by pumping $45 billion of taxpayer money into its arm. Since then, the Obama administration has looked the other way as the bank committed an astonishing variety of crimes – some elaborate and brilliant in their conception, some so crude that they'd be beneath your average street thug. Bank of America has systematically ripped off almost everyone with whom it has a significant business relationship, cheating investors, insurers, depositors, homeowners, shareholders, pensioners and taxpayers. It brought tens of thousands of Americans to foreclosure court using bogus, "robo-signed" evidence – a type of mass perjury that it helped pioneer. It hawked worthless mortgages to dozens of unions and state pension funds, draining...
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...operated by one person (or married couple that files taxes jointly). There are many advantages when considering this type, to include easy starting up and dissolving, complete control over decisions, and sole ownership of all profits. There are companies and corporations that started out as sole proprietorship. Wal-Mart (Editorial Board, 2011) started out this way and grew to be one of the biggest retail stores. Ebay was started by Pierre Omidyar (Director, Apr2006). In 1995 he set up a small internet site as an experiment. It quickly became one of the most popular sites on the net. Today eBay is a $50 billion economic giant. The biggest disadvantage to this is that the owner can lose personal assets in the event the business folds. This means his home, bank accounts, and other assets can be seized to pay off debts. Also you must obtain the start-up money on your own. The second, is partnership. In a partnership, two or more people co-own the business. Partners...
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...main point, is that there are two types of entrepreneurs he uses in the book in order to separate the Robber Barons from the entrepreneurs, which I will discuss a little later. Robber Baron is a term that is used for entrepreneurs during the 19th century that used questionable or unethical means to build/attain wealth. They payed there workers low wages while also buying out the competitors that could not keep up with them. Once the competition was brought out and that company was the last one standing they would jack up their prices. As I discussed earlier, Burton Folsom separated the entrepreneurs into two groups, one he classifies as the political entrepreneurs, these are the entrepreneurs that tried to succeed through federal aid, pools, vote buying, or stock speculation. These are the entrepreneurs that rely heavily on government help and subsidies. The other group that he refers to is classified as market entrepreneurs, these are the entrepreneurs that tried to succeed by creating...
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...exchange specialists will hedge the company’s exposure to currency movements using futures and options. Yet these two very different tasks share one goal—trying to control the company’s exposure to financial distress. On the face of it, then, unifying the management of a company’s diverse risks would seem a ripe source of efficiency gains and cost savings. But until recently that hasn’t really been a practical option, since no insurers offered coverage for a company’s consolidated risk exposure. A Brave Pioneer A few companies have now begun to work with insurers to develop more comprehensive risk-management agreements. And they’re finding that such policies not only save them money but bring wider organizational and strategic benefits as well. One of these is the U.S. engineering giant Honeywell. Through an innovative insurance contract it developed in partnership with its main insurer, American International Group (AIG), Honeywell has successfully integrated its management of several different kinds of risks. Under this single policy, Honeywell now groups together not only traditionally insurable risks—product liability, property, employee crime, and so on—but also protection against changes in a host of foreign exchange rates. Previously, the insurance risk-management unit in Honeywell’s treasury department had covered each risk under a separate policy, while its derivatives group hedged currency risks through the usual array of forwards, futures, and options. ...
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