How Psychological Pitfalls Generated the Global Financial Crisis (3 of 5)

Incentives and Governance at UBS.

In theory, compensation provides managers with incentives to maximize the value of their firms. Incentive compensation frameworks (beyond the base salary) often rely on a combination of (1) a bonus plan that relates to the short term and (2) equity-based compensation that relates to the long term.

In practice, UBS’s compensation system was plagued by at least three serious flaws. The first flaw was that UBS’s incentive structure did not take risk properly into account. The report states, “The compensation structure generally made little recognition of risk issues or adjustment for risk/other qualitative indicators" (p. 42).

Did this amount to rational governance? Keep in mind that fundamental value is based on discounted cash flow, where the discount rate reflects risk as well as the time value of money. Higher risk leads to a higher discount rate and, therefore, to lower discounted cash flows. UBS’s compensation structure barely took risk issues into consideration and made little to no adjustment for risk. Therefore, employees had no direct incentive to focus on risk when making decisions, including decisions about positions involving subprime mortgages and their associated derivatives.

The second flaw concerned undue emphasis on short-term profit and loss (P&L) in overall employee compensation—specifically, bonuses—and insufficient attention to the implications of decisions about positions for long-term value. The report states, “Day1 P&L treatment of many of the transactions meant that employee remuneration (including bonuses) was not directly affected by the longer term development of positions created" (p. 42). To be sure, the compensation structure featured an equity component which could have provided UBS employees with an indirect incentive to avoid risks that were detrimental to long-term value. The bonus focus, however, dominated. Bonus payments for successful and senior fixed-income traders, including those in businesses holding subprime positions, were significant. Particularly noteworthy is that UBS based bonuses on gross revenue after personnel costs but did not take formal account of the quality or sustainability of earnings.

The third flaw was that UBS’s incentives did not differentiate between skill-based returns and returns attributable to cost advantages. The report states:

[E]mployee incentivisation arrangements did not differentiate between return generated by skill in creating additional returns versus returns made from exploiting UBS’s comparatively low cost of funding in what were essentially carry trades. There are no findings that special arrangements were made for employees in the businesses holding Subprime positions. (p. 42)

Are these reward systems, policies, and practices consistent with rational governance? The authors of the UBS report suggest not, and I concur.


One of the major elements of the financial crisis was the fact that rating agencies assigned AAA ratings to mortgage-related securities that were very risky. As a result, many investors purchased these securities under the impression that they were safe, and they found out otherwise only when housing prices declined and default rates rose. Financial intermediaries such as UBS also paid a steep price when the securities they held in inventory declined in value and became illiquid.

In this section, I discuss the psychological issues that affected the judgments and decisions made by rating agencies. The processes of planning, standards, and information sharing were the most germane processes; also important were agency issues.

Planning and Standards at S&P.

Consider some background. In August 2004, Moody’s unveiled a new credit-rating model that enabled securities firms to increase their sales of top-rated subprime mortgage-backed bonds. The new model eliminated a nondiversification penalty that was present in the prior model, a penalty that applied to concentrated mortgage risk. According to Douglas Lucas, head of CDO research at UBS Securities in New York City, Moody’s was pressured to make the change. He was quoted by Smith (2008) as having stated, “I know people lobbied Moody’s to accommodate more concentrated residential mortgage risk in CDOs, and Moody’s obliged."9

Notably, Moody’s competitor, S&P, revised its own methods one week after Moody’s did. In important ways, S&P shared traits with UBS at this time. Both firms found themselves behind their respective industry leaders and were thus susceptible to reference point–induced risk-seeking behavior.

The Wall Street Journal reported that in August 2004, S&P commercial mortgage analyst Gale Scott sent the following message to colleagues: “We are meeting with your group this week to discuss adjusting criteria for rating CDOs of real-estate assets . . . because of the ongoing threat of losing deals" (see Lucchetti 2008b). Richard Gugliada, a former S&P executive who oversaw CDOs from the late 1990s until 2005, replied to the e-mail, “OK with me to revise criteria" (see Smith 2008). The criteria for rating commercial mortgages were changed after several meetings. According to an S&P report that Scott co-wrote in May 2008, the change in criteria directly preceded “aggressive underwriting and lower credit support" (Scott 2008) in the market for commercial MBS from 2005 to 2007. The report went on to say that this change led to growing delinquencies, defaults, and losses.

Consider S&P against the backdrop of its parent organization, McGraw-Hill Companies. According to reports that appeared in the Wall Street Journal, CEO and Chairman Harold McGraw established unrealistic profit goals for his organization (Lucchetti 2008a). I suggest that these goals induced risk-seeking behavior in the rating of mortgage-related products. The Wall Street Journal reported that because McGraw-Hill had been suffering financially in other areas, it exerted pressure on S&P to expand 15–20 percent a year. McGraw-Hill’s financial services unit, which includes S&P, generated 75 percent of McGraw-Hill’s total operating profit in 2007, up from 42 percent in 2000. In 2007, the ratings business generated a third of McGraw-Hill’s revenue.

Goal setting is the basis for establishing standards and planning, through which goals are folded into strategy. S&P’s efforts to achieve its goals focused on increasing its revenues from rating mortgage-related products while keeping its costs down. In regard to the latter, Gugliada told Bloomberg that he was given tough budget targets (see Smith 2008).

According to Lucchetti (2008a), the combination of high revenue goals and low cost goals led understaffed analytical teams to underestimate the default risk associated with mortgage-related products. Before the collapse in housing prices, S&P and Moody’s earned approximately three times more from grading CDOs than from grading corporate bonds.

Consider how the ratings on mortgage-related securities came to be lowered over time. Once housing prices began to decline and homeowners began to default, raters eventually downgraded most of the AAA rated CDO bonds that had been issued in the prior three years. On 10 July 2008, Moody’s reduced its ratings on $5.2 billion in subprime-backed CDOs. The same day, S&P said it was considering reductions on $12 billion of residential MBS. By August 2007, Moody’s had downgraded 90 percent of all asset-backed CDO investments issued in 2006 and 2007, including 85 percent of the debt originally rated Aaa. S&P reduced 84 percent of the CDO tranches it had rated, including 76 percent of all those rated AAA.10

Information Sharing at S&P.

Former employees at S&P have provided insights into the ways that information used for rating CDOs was shared. Kai Gilkes is a former S&P quantitative analyst in London. The following comments in Smith (2008) recreate the tenor of the discussion about the sharing of information and points of view:

“Look, I know you’re not comfortable with such and such [an] assumption, but apparently Moody’s are even lower, and, if that’s the only thing that is standing between rating this deal and not rating this deal, are we really hung up on that assumption?" You don’t have infinite data. Nothing is perfect. So the line in the sand shifts and shifts, and can shift quite a bit.

Gilkes’ remark about shifting sands needs to be understood in the context of group processes. The behavioral decision literature emphasizes that working in a group tends to reduce the biases of the group’s members when the tasks feature clearly correct solutions, which everyone can confirm once the solution has been presented. For judgmental tasks that have no clearly correct solution, however, working in groups actually exacerbates the biases of the group members. Gilkes’ remark about “shifting sands" effectively points to the judgmental character of the ratings decision.

Additional insight about the sharing of information and exchange of viewpoints has come from Gugliada, who told Bloomberg that when a proposal to tighten S&P’s criteria was considered, the codirector of CDO ratings, David Tesher, responded: “Don’t kill the golden goose."

Was groupthink an issue here, or were managers behaving rationally? The answer might depend on their personal ethics. In retrospect, Gugliada stated, competition with Moody’s amounted to a “market-share war where criteria were relaxed. . . . I knew it was wrong at the time. It was either that or skip the business. That wasn’t my mandate. My mandate was to find a way" (see Smith 2008). In this regard, Griffin and Tang (2009) find that ratings by both firms were higher than what their models implied. They conclude that tranches that were rated AAA actually corresponded to BBB when rated according to the firms’ models and default standards.

To be sure, analysts at S&P were not oblivious to the possibility of a housing bubble. In 2005, S&P staff observed that the housing market was in a bubble, the bursting of which might lead housing prices to decline by 30 percent at some stage. The vague “at some stage" could have meant, however, next month or 10 years hence. The timing of the bursting of a bubble is highly uncertain. The report, including its implications for ratings, was discussed internally, but the discussion did not alter the rating methodology.

S&P had been telling investors that their ratings were but one piece of information about securities and that ratings were not a perfect substitute for being diligent about acquiring additional information to assess security risk. S&P’s protocol was to accept the documentation as presented and to issue a rating conditional on that information. The firm’s practice was not to verify the documentation. If S&P rated a security on the basis of limited-documentation mortgages, it did not seek to verify whether or not the information was correct. Just as UBS did, however, the investment bank treated AAA ratings on mortgage-related securities as unconditional ratings. Moreover, the same was true for many other investors, especially end investors, who were much less sophisticated than investment bankers.

As it happens, some of the analysts engaged in rating CDOs were highly skeptical of their assignments, and they shared this skepticism with colleagues. Lucchetti (2008b) reports that one S&P analytical staffer e-mailed another saying that a mortgage or structured-finance deal was “ridiculous" and that “we should not be rating it." The recipient of the e-mail famously responded, “We rate every deal," and added that, “it could be structured by cows and we would rate it." An analytical manager in the CDO group at S&P told a senior analytical manager in a separate e-mail that “rating agencies continue to create" an “even bigger monster—the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters" [Lucchetti 2008b].


AIG is an insurance company with a financial products division (AIGFP).11 Because of AIGFP’s involvement in the market for subprime mortgages, AIG required a $182 billion bailout from the U.S. government. In September 2008, the decision to bail out AIG was a defining moment in the unfolding of the global financial crisis. To understand the decisions that led to this event, consider some background.

AIGFP was created in 1987; it generated income by assuming various parties’ counterparty risks in such transactions as interest rate swaps. It was able to do so because its parent, AIG, had an AAA rating and a large balance sheet. AIGFP was highly profitable during its first 15 years and, by 2001, was generating 15 percent of AIG’s profit.

AIGFP’s main role in the global financial crisis involved its trades in the market for CDS associated with subprime mortgages. Effectively, AIG provided insurance against defaults by homeowners who had taken out subprime mortgages.

AIGFP entered the market for CDS in 1998 by insuring against the default risk of corporate bonds issued by investment-grade public corporations. The default risk associated with these bonds as a group was relatively low. Although insuring corporate debt remained AIGFP’s key business, over time the company also began to insure risks associated with credit card debt, student loans, auto loans, pools of prime mortgages, and eventually, pools of subprime mortgages.

Planning and Risk Standards at AIGFP.

The need for a bailout of AIG stemmed from AIGFP having underestimated its risk exposure to subprime mortgages. The psychological pitfalls underlying the underestimation were categorization, overconfidence, and groupthink.

When the Federal Reserve began to increase short-term interest rates in June 2004, the volume of prime mortgage lending fell by 50 percent. At the same time, however, the volume of subprime mortgage lending increased dramatically.12 Lewis (2009) related that, as a result, the composition of mortgage pools that AIGFP was insuring shifted over the next 18 months; the proportion of mortgages that were subprime increased from 2 percent to 95 percent of the total over that period. Yet, AIGFP’s decisions were invariant to the change. The decision makers succumbed to categorization; that is, they treated a pool with 2 percent subprime mortgages as equivalent to a pool with 95 percent subprime mortgages.

Recall the failure of the rational lemons paradigm. A major reason the subprime market thrived instead of collapsed is that during 2004 and 2005, AIGFP assumed the default risk of subprime mortgages apparently unknowingly. AIGFP failed to assume the worst, as rational behavior in the lemons framework requires.

In addition to categorization, overconfidence and groupthink played key roles. AIGFP was headed by Joseph Cassano. His predecessor at the helm of AIGFP was Tom Savage, a trained mathematician who understood the models used by AIGFP traders to price the risks they were assuming. Savage encouraged debates about the models AIGFP was using and the trades being made. According to Lewis (2009), in contrast to Savage, Cassano stifled debate and intimidated those who expressed views he did not share. Cassano was not a trained mathematician. His academic background was in political science, and he spent most of his career in the back office doing operations. Lewis reports that his reputation at AIGFP was someone who had a crude feel for financial risk and a strong tendency to bully people who challenged him. One of his colleagues said of him, “The way you dealt with Joe was to start everything by saying, ‘You’re right, Joe.’" When the issue of a shift toward taking more subprime mortgage risk eventually made its way onto a formal agenda, Cassano, pointing to the AAA ratings from Moody’s and S&P, dismissed any concerns as overblown.

Eventually, Cassano did change his mind. It happened when he was persuaded to meet with a series of AIGFP’s Wall Street trading partners to discuss the premises underlying the rating of CDO tranches based on subprime mortgages. Cassano learned that the main premise was that the historical default rate for the U.S. housing market would continue to apply in the future, a judgment consistent with conservatism bias. To his credit, Cassano did not accept the premise, and at the end of 2005, AIGFP ceased its CDS trades.

AIGFP’s decision to stop insuring mortgage defaults did not stop Wall Street firms from continuing to create CDOs based on subprime mortgages. It did force Wall Street firms to bear some of the default risk, however, that AIGFP had previously borne. That outcome is a major reason Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns took the losses they did.

In August 2007, in a conference call to investors, Cassano made the following statement: “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 $1 on any of those transactions." Major surprises are the hallmark of overconfidence. Cassano apparently based his statement on the fact that the subprime mortgages that were beginning to default had originated in 2006 and 2007, which were riskier years for mortgage issuance than 2004 and 2005, the years in which AIGFP had taken its CDS positions. The CDS contracts on which Cassano had signed off stipulated, however, that AIG would post collateral if its credit rating were downgraded. As it happens, AIG’s credit rating did come to be downgraded, in September 2008 from AA to A, thereby triggering calls for collateral that AIG was unable to meet.

Incentives and Governance at AIGFP.

Poor incentives were not the problem at AIGFP, which balanced long-term against short-term results. To its credit, AIGFP required that employees leave 50 percent of their bonuses in the firm, a policy that skewed their incentive toward the long run.13 As for Cassano, in 2007, he was paid $38 million in total, but he left almost all of that amount ($36.75 million) in the firm. Clearly, he had a strong financial incentive to maximize the long-term value of AIG. His decisions destroyed value at AIG, however, and nearly brought down the firm.

Why did Cassano behave in ways that seem highly irrational? The reason is that when it comes to behaving rationally, psychological pitfalls can trump incentives. Good governance involves more than structuring good incentives.

A host of additional governance questions can be raised about AIG. Why did AIGFP’s board of directors agree to appoint someone with Cassano’s temperament to head the division? How thoroughly did the executives at the parent firm monitor Cassano’s actions? To what extent did the resignation of AIG CEO Hank Greenberg in March 2005 make a difference to the risks assumed by the firm as a whole?

Most of these questions are difficult to answer. We do know that Greenberg, who had run AIG since 1968, was known for being a diligent monitor. His successor, Edward Liddy, lacked Greenberg’s deep understanding of the company. For the six-month period preceding the bailout, the firm had neither a full-time chief financial officer nor a chief risk assessment officer and was engaged in a search for both. As a result, in the period leading up to the bailout, the executives of the 18th-largest firm in the world had no clear sense of their firm’s exposure to subprime mortgage risk.


At the end of the supply chain for the financial products in this story are the investors who purchased and held the complex securities at the heart of the tale. Narvik, Norway, population 17,000 and located above the Arctic Circle, is just such an investor. It was featured in a February 2009 CNBC documentary titled “House of Cards," which explored issues surrounding the financial crisis.14 Narvik had been losing population and its tax base. To address the issue, its local council invested $200 million in a series of complex securities that included CDOs. The purchase of the CDOs was part of a larger strategy in which the town took out a loan, using as collateral future revenues from its hydroelectric plant, and invested the proceeds in complex securities with the intent of capturing the spread. Narvik ended up losing $35 million, roughly a quarter of its annual budget.

Two main psychological features tie the situation in Narvik to the discussion in previous sections. First, given the decline in population and tax revenues, the council members in Narvik quite plausibly exhibited reference point–induced risk-seeking behavior. They were fiduciary managers of cash flows derived from their hydroelectric plant, but because money and population were higher in the past, they swapped those monies for what they hoped would be higher cash flows from U.S. mortgages and municipal bond payments.

Second, the mayor of Narvik at the time, Karen Kuvaas, insists that the council members were not naive, but in this respect, she might have been overconfident; she also admits that she did not read the prospectus before signing off on the deal and was not aware that if some of the securities declined in value, Narvik would have to post payments. In defense of the council, Kuvaas indicated that the securities they purchased were represented to them as AAA rated and, therefore, as very safe.

The lesson here is that fiduciaries or other agents who may be knowledgeable enough in one set of circumstances may be way over their heads in another. One should always be on the lookout to see if one is falling prey to overconfidence.


The SEC came under intense criticism for its lax oversight of investment banking practices and for failing to detect a large hedge fund Ponzi scheme run by Bernard Madoff.

A focal point of the criticism of investment bank oversight involved a meeting that took place at the SEC on 28 April 2004, when the commission was chaired by William Donaldson. That meeting established the Consolidated Supervised Entities (CSE) program, a voluntary regulatory program that allowed the SEC to review the capital structure and risk management procedures of participating financial institutions. Five investment banks joined the CSE program, as did two bank holding companies. The investment banks were Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley, and the bank holding companies were Citigroup and JPMorgan Chase.

As part of the CSE program, the SEC agreed to a change in elements of the net capital rule, which limited the leverage of broker/dealer subsidiaries. Some analysts have suggested that this change led the CSE participants to increase their leverage—from approximately 12 to 1 to ratios exceeding 30 to 1—thereby greatly magnifying the losses these institutions later incurred on their subprime mortgage positions (Labaton 2008; Coffee 2008).

Prior to 2004, the SEC had limited authority to oversee investment banks. In 2004, the European Union passed a rule permitting the SEC’s European counterpart to oversee the risk of both broker/dealers and their parent holding companies. This change could have meant that the European divisions of U.S. financial institutions would be regulated by European agencies, but the European Union agreed to waive regulatory oversight by its own agencies if equivalent oversight was provided by the host countries’ agencies. This policy is what led the SEC to institute the CSE program, although the SEC required that the entities be large firms, firms with capital of at least $5 billion. Indeed, U.S investment banks, anxious to avoid European oversight, lobbied the SEC for the change.

The change to the net capital rule made it consistent with the Basel II standards. The key feature of the change was an alteration in the way net capital is measured. Prior to the change, net capital was measured by financial statement variables and was subject to formulaic discounts (“haircuts") to adjust for risk. The main change to the rule replaced the formulaic approach with discounts derived from the risk management models in use at the financial institutions.

Controversy surrounds the impact associated with the change to the net capital rule. The New York Times first reported the change to the rule (Labaton (2008), and this report was subsequently echoed by academics (e.g., Coffee 2008). The coverage by the New York Times might have been misleading, however, in that it suggested that this change allowed the leverage levels at parent holding companies to grow from 15 to above 30, thereby exacerbating faulty decisions about subprime mortgages. The SEC maintains that the change in provisions of the net capital rule applied to broker/dealer subsidiaries and had no discernible impact on the degree of leverage of the parent holding companies. Sirri (2009) argued that the change in the net capital rule left the same leverage limits in place and changed only the manner in which net capital is measured.15

Perhaps the most important feature of the CSE program was the SEC’s failure to provide effective oversight of the risk profiles at the financial institutions in question. Consider the following remarks by Coffee (2008):

Basel II contemplated close monitoring and supervision by regulators. Thus, the Federal Reserve assigns members of its staff to maintain an office within a regulated bank holding company in order to provide constant oversight. In the case of the SEC, a team of only three SEC staffers were [sic] assigned to each CSE firm (and a total of only 13 individuals comprised the SEC’s Office of Prudential Supervision and Risk Analysis that oversaw and conducted this monitoring effort). From the start, it was a mismatch: three SEC staffers to oversee an investment bank the size of Merrill Lynch, which could easily afford to hire scores of highly quantitative economists and financial analysts, implied that the SEC was simply outgunned.

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9 Interestingly, Lucas had been an analyst at Moody’s and claims to have invented the diversity score in the late 1980s.

10 Still, in the last week of August 2007, Moody’s assigned Aaa grades for at least $12.7 billion of new CDOs, which would be downgraded within six months.

11 The source material for AIG is Lewis (2009).

12 In 2003, the volume of subprime mortgages was less than $100 billion. Between June 2004 and June 2007, the volume of subprime loans increased to $1.6 trillion and Alt-A loans (limited-documentation loans) increased to $1.2 trillion.

13 When AIG collapsed, employees lost more than $500 million of their own money.

14 A video of the program is available at

15 The purpose of the net capital rule is not to limit overall leverage at financial institutions, so the rule did not impose leverage restrictions on parent holding companies. The rule’s purpose was to provide protection of such assets as consumer receivables in case of liquidation by a broker/dealer. Indeed, leverage ratios for the major investment banks during the late 1990s averaged 27, well above the maximum ratio associated with the net capital rule.


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