How Psychological Pitfalls Generated the Global Financial Crisis (2 of 5)


Behavioral corporate finance highlights the psychological errors and biases associated with major corporate tasks—capital budgeting, capital structure, payout policy, valuation, mergers and acquisitions, risk management, and corporate governance. In my 2008 book, I suggested that suboptimal corporate financial decisions can largely be traced to the impact of psychological errors and biases on specific organizational processes (Shefrin 2008b). These processes involve planning, the setting of standards, the sharing of information, and incentives. Planning includes the development of strategy and the preparation of pro forma financial statements. Standards involve the establishment of goals and performance metrics. Information sharing results from the nature of organizational design. Incentives stem from the compensation system and are a major aspect of corporate governance. Sullivan (2009) emphasized the importance of governance failures in generating the crisis.

Among the main psychological pitfalls at the center of behavioral finance are the following:

  • reference point–induced risk seeking,
  • narrow framing,
  • opaque framing,
  • excessive optimism,
  • overconfidence,
  • extrapolation bias,
  • confirmation bias,
  • conservatism,
  • the “affect heuristic,"
  • “groupthink,"
  • hindsight bias, and
  • categorization bias.

I suggest that these pitfalls figured prominently in the decisions that precipitated the financial crisis. For this reason, I provide here a brief description of each.

Psychologically based theories of risk taking emphasize that people measure outcomes relative to reference points. A reference point might be a purchase price used to define gains and losses, as suggested by Shefrin and Statman (1985), building on Kahneman and Tversky (1979), or a level of aspiration, as suggested by Lopes (1987). Reference point–induced risk seeking is the tendency of people to behave in a risk-seeking fashion to avoid an outcome that lies below the reference point. As an illustration, consider El-Erian’s comment that as risk premiums declined from 2004 on, investors used leverage in a determined effort “to squeeze out additional returns." This comment is consistent with the idea that investors had fixed aspirations and became more tolerant of risk as risk premiums declined.

Narrow framing is the practice of simplifying a multidimensional decision problem by decomposing it into several smaller subtasks and ignoring the interaction between these subtasks. The term “silo" is sometimes used to describe the impact of narrow framing because subtasks are assigned to silos.

Opaque framing versus transparent framing involves the level of clarity in the description of the decision task and associated consequences. For illustration, consider El-Erian’s comment about institutions taking risk beyond what they can understand and process. This comment suggests opaque, or nontransparent, framing.

Excessive optimism leads people to look at the world through rose-colored glasses. Overconfidence leads people to be too sure of their opinions, a tendency that frequently results in their underestimating risk. Although excessive optimism and overconfidence sound related, they are really quite different psychological shortcomings in a decision maker. For example, somebody might be an overconfident pessimist—one who has too much conviction that the future will be gloomy.

Extrapolation bias leads people to forecast that recent changes will continue into the future. A pertinent example of extrapolation bias is the belief that housing prices will continue to grow at the same above-average rates that have prevailed in the recent past.

Confirmation bias leads people to overweight information that confirms their prior views and to underweight information that disconfirms those views.

Conservatism is the tendency to overweight base-rate information relative to new (or singular) information. This phenomenon is sometimes called “underreaction."

The affect heuristic refers to the making of judgments on the basis of positive or negative feelings rather than underlying fundamentals. Reliance on the affect heuristic is often described as using “gut feel" or intuition.

Groupthink leads people in groups to act as if they value conformity over quality when making decisions. Groupthink typically occurs because group members value cohesiveness and do not want to appear uncooperative so they tend to support the positions advocated by group leaders rather than playing devil’s advocate. Group members may also be afraid of looking foolish or poorly informed if they vocally disagree with a leader whom the majority of the group regards as wise.

Hindsight bias is the tendency to view outcomes in hindsight and judge that these outcomes were more likely to have occurred than they appeared in foresight. That is, ex post, the ex ante probability of the event that actually occurred is judged to be higher than the ex ante estimate of that ex ante probability. Consider Posner’s (2009b) comment about equities being efficiently priced in the late 1990s or houses being efficiently priced in the first six years of this decade. In making this claim, he effectively charges Akerlof and Shiller (2009) with succumbing to hindsight bias in that he suggests that the subsequent price decline is nothing more than an unfavorable outcome that is being viewed as more likely in hindsight than it was in foresight.

Categorization bias is the act of partitioning objects into general categories and ignoring the differences among members of the same category. Categorization bias may produce unintended side effects if the members of the same category are different from each other in meaningful ways.

In the remainder of this article, I use the behavioral corporate finance framework to analyze each of five cases. One way to think about this framework is in terms of the interaction of psychological biases with business processes, as illustrated in Exhibit 1. (Exhibit 1 is merely for illustration; only the first five pitfalls discussed in this section are displayed.) The intersections of the rows showing organizational processes with the columns depicting psychological pitfalls are shown as question marks to prompt questions for those using such a framework about whether a specific pitfall occurred as part of the business process. This perspective helps to show how psychological pitfalls affect the decisions made in connection with each process.


At the end of 2007, UBS announced that it would write off $18 billion of failed investments involving the subprime housing market in the United States. In 2008, the write-offs increased to more than $50 billion. In October 2008, the Swiss central bank announced its intention to take $60 billion of toxic assets off UBS’s balance sheet and to inject $6 billion of equity capital.

In April 2008, UBS published a report (2008) detailing the reasons for its losses. In this section, I quote extensively from the report to let UBS management speak for itself.

The report states, “UBS’s retrospective review focused on root causes of these losses with the view toward improving UBS’s processes" (p. 28). That is, the write-offs were the result of having ineffective processes in place, a statement that, I argue, failed to address psychological biases. In the following discussion, I view the UBS report through the prism of the four specific processes shown in Exhibit 1: planning, standards, information sharing, and incentives. As readers will see, biases permeated many of the decisions UBS made in connection with subprime mortgages and financial derivatives.

Planning at UBS.

The report states, “[T]he 5 year strategic focus articulated for 2006–2010 was to aim for significant revenue increases whilst also allowing for more cost expansion. However the Group’s risk profile in 2006 was not predicted to change substantially . . . ." (p. 8). In retrospect, the firm’s risk profile did increase dramatically, which raises the question of whether UBS’s management team displayed overconfidence.

UBS says that in 2005 it engaged the services of an external consultant, who compared UBS’s past performance with that of its chief competitors.6 Notably, UBS’s performance trailed those of its competitors. To close the competitive gap, the consultant recommended the following:

[S]trategic and tactical initiatives were required to address these gaps and recommended that UBS selectively invest in developing certain areas of its business to close key product gaps, including in Credit, Rates, MBS Subprime and Adjustable Rate Mortgage products (“ARMs"), Commodities and Emerging Markets. ABS (asset backed securities), MBS, and ARMs (in each case including underlying assets of Subprime nature) were specifically identified as significant revenue growth opportunities. The consultant’s review did not consider the risk capacity (e.g. stress risk and market risk) associated with the recommended product expansion. (p. 11)

Notice that, although subprime was specifically identified as providing significant revenue growth opportunities, the consultant’s review did not consider the implications for UBS’s risk capacity. Given that risk and return lie at the heart of finance and that subprime mortgages feature more default risk than higher rated mortgages, the absence of an analysis of risk is striking.7

Standards for Risk at UBS.

Standards for risk management include targets and goals that relate to accounting controls and include position limits and other risk-control mechanisms. The report tells how UBS reacted to the consulting firm’s failure to address the implications of its recommendations for risk:

There were not however any Operational Limits on the CDO Warehouse, nor was there an umbrella Operational Limit across the IB [the investment banking unit] (or the combination of IB and DRCM [the hedge fund subsidiary Dillon Read Capital Management]) that limited overall exposure to the Subprime sector (securities, derivatives and loans). (p. 20)

That is, UBS did not develop any operational limits that would restrict the firm’s overall exposure to subprime loans, securities, and derivatives.

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Was this behavior rational, or did UBS irrationally ignore risk for psychological reasons? One possibility is that by virtue of being behind the competition, UBS set a high reference point for itself and exhibited reference point–induced risk-seeking behavior. Perhaps this attitude is why it did not question the consulting firm’s failure to address the risk implications of its recommendations and did not develop risk standards for itself. Its psychological profile led it to act as if it implicitly attached little or no value to avoiding risk.

UBS’s internal report does indeed suggest that the reference point for the company corresponded to the superior performance of its competitors. The report states:

It was recognized in 2005 that, of all the businesses conducted by the IB, the biggest competitive gap was in Fixed Income, and that UBS’s Fixed Income positioning had declined vis-à-vis leading competitors since 2002. In particular, the IB’s Fixed Income, Rates & Currencies (“FIRC") revenues decreased since 2004, and accordingly, FIRC moved down in competitor league tables by revenue. According to an external consultant, the IB Fixed Income business grew its revenue at a slower rate than its peers. (p. 10)

CDOs are akin to families of mutual funds that hold bonds instead of stocks. Each member of the fund family, or tranche, holds bonds with a different degree of priority in the event of default from the priority of other tranches in the family. Investors pay lower prices for riskier tranches. Holders of the equity (riskiest) tranche absorb the first losses stemming from default. If at some point the holders of the equity tranche receive zero cash flows from the underlying assets, holders of the next tranche begin to absorb losses. Holders of the senior tranche are the most protected, but the existence of a “super senior" tranche is also possible. If the CDO contains leverage, meaning that the issuer of the CDO borrowed money to purchase assets for the CDO, then some party must stand ready to absorb the losses once the holders of even the senior tranche receive no cash flows. Holders of the super senior tranche must play this role. Instead of paying to participate in the CDO, they receive payments that are analogous to insurance premiums.

UBS’s investment banking unit did hold super senior positions, and that unit did consider the risk of those positions. Moody’s and S&P both rated various CDO tranches. The report states:

MRC [Market Risk Control] VaR [value-at-risk] methodologies relied on the AAA rating of the Super Senior positions. The AAA rating determined the relevant product-type time series to be used in calculating VaR. In turn, the product-type time series determined the volatility sensitivities to be applied to Super Senior positions. Until Q3 [third quarter] 2007, the 5-year time series had demonstrated very low levels of volatility sensitivities. As a consequence, even unhedged Super Senior positions contributed little to VaR utilisation. (p. 20)

Piskorski, Seru, and Vig (2009) found, conditional on a loan becoming seriously delinquent, a significantly lower foreclosure rate for loans held by banks than for similar loans that were securitized. Indeed, Eggert (2009) takes the position that securitization caused the subprime meltdown. In this regard, UBS’s behavior provides examples of key psychological pitfalls related to securitization. For instance, in relying solely on risk ratings, UBS’s risk management group did no independent analysis. The report states:

In analyzing the retained positions, MRC generally did not “look through" the CDO structure to analyse the risks of the underlying collateral. In addition, the CDO desk does not appear to have conducted such “look through" analysis and the static data maintained in the front-office systems did not capture several important dimensions of the underlying collateral types. For example, the static data did not capture FICO [credit] scores, 1st/2nd lien status, collateral vintage (which term relates to the year in which the assets backing the securities had been sourced), and did not distinguish a CDO from an ABS. MRC did not examine or analyze such information on a regular or systematic basis. (p. 20)

In a similar vein, it appears that no attempt was made to develop an RFL [risk factor loss] structure that captured more meaningful attributes related to the U.S. housing market generally, such as defaults, loan to value ratios, or other similar attributes to statistically shock the existing portfolio. (p. 38)

Was it rational for UBS to ignore the underlying fundamentals of the U.S. mortgage market? Was it rational for UBS to make no attempt to investigate key statistics related to the U.S. housing market, such as LTVs, percentage of loans that featured 100 percent financing, limited-documentation loans, and default rates? Between 2001 and 2006, the following occurred: The LTVs of newly originated mortgages rose from 80 percent to 90 percent; the percentage of loans that were 100 percent financed climbed from 3 percent to 33 percent; and limited-documentation loans almost doubled—rising from 27 percent to 46 percent. In terms of increasing risk, these trends are akin to powder kegs waiting for a match.8

As for defaults, the insufficient focus on fundamentals, in combination with an overattention to historical default rates—a strong illustration of conservatism bias (i.e., the tendency to overweight base-rate information)—gave rise to the “risk-free illusion." UBS’s CDO desk considered a super senior position to be fully hedged if 2–4 percent of the position was protected. They referred to such super seniors as AMPS (amplified mortgage protected trades). In this regard, UBS erroneously judged that it had hedged its AMPS positions sufficiently and that the associated VaR was effectively zero.

Was this judgment rational? Not in my opinion, as UBS assumed that historical default rates would continue to apply, despite the changed fundamentals in the U.S. housing market. The UBS report indicates in respect to AMPS that

Amplified Mortgage Portfolio: . . . at the end of 2007, losses on these trades contributed approximately 63% of total Super Senior losses.

Unhedged Super Senior positions: Positions retained by UBS in anticipation of executing AMPS trades which did not materialise. . . . at the end of 2007, losses on these trades contributed approximately 27% of total Super Senior losses. (p. 14)

Information Sharing at UBS.

Narrow framing and opaque framing are two of the psychological pitfalls described previously. UBS’s report criticizes its risk managers for opaquely presenting information about risks to be managed and decisions to be taken. The report states:

Complex and incomplete risk reporting: . . . Risks were siloed within the risk functions, without presenting a holistic picture of the risk situation of a particular business.

Lack of substantive assessment: MRC did not routinely put numbers into the broader economic context or the fundamentals of the market when presenting to Senior Management. (p. 39)

When risk managers eventually recognized the deteriorating values of their subprime positions, they mistakenly assumed that the problem was restricted to subprime and would not affect the values of their other ABS positions.

As a general matter, risk managers did not properly share information with those who needed the information at UBS, and the information they did share was overly complex and often out of date. Examples of what went wrong are that risk managers often netted long and short positions, which obscured the manner in which positions were structured, and they did not make the inventory of super senior positions clear.

Information sharing takes place as part of the deliberations about which decisions to take. UBS managers exhibited groupthink in these deliberations by not challenging each other about the ways their various businesses were developing. The report states:

Members of the IB Senior Management apparently did not sufficiently challenge each other in relation to the development of their various businesses. The Fixed Income strategy does not appear to have been subject to critical challenge, for instance in view of the substantial investments in systems, people and financial resources that the growth plans entailed. (p. 36)

UBS’s risk managers also appeared vulnerable to confirmation bias. As the firm began to experience losses on its inventories of MBS in the first and second quarters of 2007, the risk management team did not implement additional risk methodologies. Then, matters got worse. In a subsection titled “Absence of risk management," the report states:

In Q2 2007, the CDO desk was giving a relatively pessimistic outlook in relation to certain aspects of the Subprime market generally in response to questions from Group and IB Senior Management about UBS’s Subprime exposures. Notwithstanding this assessment, the MBS CDO business acquired further substantial Mezz RMBS [mezzanine residential MBS] holdings and the CDO desk prepared a paper to support the significant limit increase requests. The increase was ultimately not pursued. (p. 29)

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6 UBS relied on McKinsey & Company for consulting services. Peter Wuffli, who was UBS Investment Bank CEO at the time, had previously been a principal with McKinsey.

7 The nature of the consultant’s recommendation provides an interesting illustration of how a “follow the leader" approach results in herding. UBS followed a leader in its peer group, plausibly Lehman Brothers although they do not say so explicitly. As I report later, a consultant advised Citigroup also to increase its risk exposure. Shefrin (2009) discussed how Merrill Lynch sought to emulate the subprime strategy of the industry leader (at the time, Lehman Brothers).

8 In this regard, the President’s Working Group on Financial Markets (2008) concluded, “The turmoil in financial markets was triggered by a dramatic weakening of underwriting standards for U.S. subprime mortgages, beginning in late 2004, and extending into early 2007." In contrast, studies by Bhardwaj and Sengupta (2008a, 2008b) from the Federal Reserve Bank of St. Louis suggest that subprime mortgage quality did not deteriorate after 2004 because FICO scores improved at the same time that the other indicators of credit quality worsened. The authors also pointed out that adjustable-rate subprime mortgages are designed as bridge loans, with the view that they be prepaid when interest rates reset as homeowners refinance. They attributed the subprime meltdown to the decline in housing prices that began at the end of 2006 rather than to a lowering of lending standards.


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