How Psychological Pitfalls Generated the Global Financial Crisis (4 of 5)

Planning at the SEC.

Did the SEC display overconfidence in its planning process for the CSE program? Perhaps. Evidence suggesting overconfidence can be observed in the following two excerpts from the transcript of the 28 April 2004 meeting. In the excerpt, Harvey Goldschmid, who was an SEC commissioner at the time, directs a question to an SEC staffer:16

Harvey Goldschmid: We’ve talked a lot about this. This is going to be much more complicated—compliance, inspection, understanding of risk—than we’ve ever had to do. Mike, I trust you no end. But I take it you think we can do this?
Group: [Laughter.]
Mike: Well we’ve hired Matt Eichler and other folks as well who are skilled in quantitative analysis. They’re both PhDs right now. And we’ve hired other people as well who are quantitatively skilled. So we’re going to continue to develop that staff. And then we have a good accounting staff as well. And then our auditors in New York, as well as in Washington will be useful in this process.
I mean, so we’re going to have to depend on the firms, obviously. They’re frontline. They’re going to have to develop their entire risk framework. We’ll be reading that first. And they’ll have to explain that to us in a way that makes sense. And then we’ll do the examinations of that process. In addition to approving their models and their risk control systems.
It’s a large undertaking. I’m not going to try to do it alone.
Group: [Laughter.]

The two instances of group laughter in the above excerpt mark points at which “Mike" might have exhibited overconfidence about his ability to oversee risk management at seven major financial institutions with combined assets of about $4 trillion with the help of only two PhDs, some additional quantitatively oriented personnel, and agency accountants and auditors.17

Consider a second excerpt involving Goldschmid and Annette Nazareth, who at the time was the SEC director of the Division of Market Regulation. Their interchange is particularly interesting in light of the later collapse of Bear Stearns, Lehman Brothers, and Merrill Lynch:

Goldschmid: We’ve said these are the big guys but that means if anything goes wrong, it’s going to be an awfully big mess.
Group: [Laughter.]
Annette Nazareth: Again, we have very broad discretionary . . . . As we mentioned, we’re going to be meeting with these firms on a monthly basis. And hopefully from month to month you don’t see wild swings. Among other things, we can require firms to put in additional capital, to keep additional capital against the risks. We can actually—the commission has the authority to limit their ability to engage in certain businesses, just as any prudent regulator would. We have hopefully a lot of early warnings and the ability to constrict activity that we think is problematic.
Goldschmid: I think you’ve been very good at thinking this through carefully and working this through with skill . . . .

The deliberations to establish the CSE program lasted less than an hour. The vote by the SEC was unanimous. Little probing for weaknesses in such a far-reaching proposal occurred. I suggest that overconfidence and confirmation bias were high. This kind of setting is where groupthink thrives.

Goldschmid left the commission in 2005. In an October 2008 interview with the New York Times, he reflected: “In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the SEC didn’t oversee well enough" (Labaton 2008). I suggest that this recollection indicates that Goldschmid was overconfident in 2004.

Although Goldschmid was apparently overconfident at that time, other forces that led to weak oversight were also at work. In April 2004, when Goldschmid was serving as one of the commissioners, the SEC was chaired by Donaldson, but in 2005, Christopher Cox replaced Donaldson. Cox was generally regarded as favoring weaker regulations, which might explain why so few resources were allocated to the CSE program. In February 2009, Linda Thomsen, the director of enforcement at the SEC, resigned under pressure. It was on her watch that Wall Street investment banks took disastrous risk management decisions and the Ponzi scheme conducted by Madoff went undetected. In describing her resignation, the press noted that she should not have to bear the entire blame for these failures because Cox set the tone, including public criticism of SEC staff, for weak regulatory oversight.

Madoff and Behavioral Pitfalls at the SEC.

According to an internal report by the SEC (2009), between 1992 and 2008, the agency received six distinct complaints about Madoff’s operations, one of which involved three versions. Several of the complaints suggested that Madoff was running a Ponzi scheme. The report reveals that the SEC conducted investigations and examinations related to Madoff’s investment advisory business but failed to uncover the fraud.

I suggest that confirmation bias lay at the heart of the SEC’s failure to detect Madoff’s Ponzi scheme. An excerpt from the SEC’s internal report follows.18 As you read through the excerpt, keep in mind that a person exhibits confirmation bias when he or she overweights information that confirms a view or hypothesis and underweights information that disconfirms the view or hypothesis. The report states:

The OIG investigation found the SEC conducted two investigations and three examinations related to Madoff’s investment advisory business based upon the detailed and credible complaints that raised the possibility that Madoff was misrepresenting his trading and could have been operating a Ponzi scheme. Yet, at no time did the SEC ever verify Madoff’s trading through an independent third-party, and in fact, never actually conducted a Ponzi scheme examination or investigation of Madoff.
In the examination of Madoff, the SEC did not seek Depository Trust Company (DTC) (an independent third-party) records, but sought copies of such records from Madoff himself. Had they sought records from DTC, there is an excellent chance that they would have uncovered Madoff’s Ponzi scheme in 1992.
The teams assembled were relatively inexperienced, and there was insufficient planning for the examinations. The scopes of the examination were in both cases too narrowly focused on the possibility of front-running, with no significant attempts made to analyze the numerous red flags about Madoff’s trading and returns . . .
The investigation that arose from the most detailed complaint provided to the SEC, which explicitly stated it was “highly likely" that “Madoff was operating a Ponzi scheme," never really investigated the possibility of a Ponzi scheme. The relatively inexperienced Enforcement staff failed to appreciate the significance of the analysis in the complaint, and almost immediately expressed skepticism and disbelief. Most of their investigation was directed at determining whether Madoff should register as an investment adviser or whether Madoff’s hedge fund investors’ disclosures were adequate.
As with the examinations, the Enforcement staff almost immediately caught Madoff in lies and misrepresentations, but failed to follow up on inconsistencies. They rebuffed offers of additional evidence from the complainant, and were confused about certain critical and fundamental aspects of Madoff’s operations. When Madoff provided evasive or contradictory answers to important questions in testimony, they simply accepted as plausible his explanations.
Although the Enforcement staff made attempts to seek information from independent third-parties, they failed to follow up on these requests. They reached out to the NASD [now, FINRA, the Financial Industry Regulatory Authority] and asked for information on whether Madoff had options positions on a certain date, but when they received a report that there were in fact no options positions on that date, they did not take any further steps. An Enforcement staff attorney made several attempts to obtain documentation from European counterparties (another independent third-party), and although a letter was drafted, the Enforcement staff decided not to send it. Had any of these efforts been fully executed, they would have led to Madoff’s Ponzi scheme being uncovered. (pp. 23–25)

People who succumb to confirmation bias test hypotheses by searching for information that confirms the hypothesis they are testing. The antidote to confirmation bias is to search for information that disconfirms the hypothesis, to ask whether the hypothesis is untrue, a lie. What the SEC report strongly indicates is that its staff actively avoided seeking disconfirming information to their view that Madoff was innocent of running a Ponzi scheme.

Confirmation bias was not the only psychological pitfall afflicting the SEC in connection with its investigations of Madoff. An incentive issue was also involved in respect to the way the SEC rewarded investigators. Nocera (2009) pointed out that the SEC bases its success on quantitative measures, such as the number of actions it brings and the number of cases it settles. He suggests that through its choice of standards and incentives, the SEC tends to pursue small cases, cases in which those being investigated will prefer to settle and pay a fine even if they are innocent. Madoff was not a small case.

Reference point–induced risk seeking was also a factor. Nocera indicated that the SEC finds it difficult to shut cases down once they have been initiated. Such behavior is throwing good money after bad, a phenomenon technically known as “escalation of commitment." Nocera stated:

Even if the facts start to look shaky, the internal dynamics of the agency push its lawyers to either settle or go to trial, but never to abandon it. [quoting] “The staff has a real problem persuading the commission to cut off a case once it has begun."19

Given the SEC’s limited resources, the costs of escalation of commitment can be very high.

In addition to confirmation bias and escalation of commitment, the SEC also exhibited poor information sharing. In this regard, the SEC report relates that the agency was unaware that it was running separate examinations out of two offices. The report states:

Astoundingly, both examinations were open at the same time in different offices without either knowing the other one was conducting an identical examination. In fact, it was Madoff himself who informed one of the examination teams that the other examination team had already received the information they were seeking from him. (p. 24)


Opinions about the root cause of the financial crisis differ. Some argue that the root lies with a weak regulatory structure, within which private-sector decisions were largely rational. Others argue that the root lies with irrational decisions associated with the occurrence of a housing market bubble, a surge in subprime mortgage lending, and the breakdown of the rational lemons paradigm. Still others blame poor corporate governance, explicit corruption, and unwise governmental mandates and guarantees. Differentiating among these various views requires a search for the devil in the details.

The details considered here involve five cases, all of which highlight (to a greater or lesser degree) irrational decision making at key points in the financial product supply chain. Consider decisions made at AIG. AIG facilitated the explosive growth in subprime mortgage lending in 2004 and 2005 by selling CDS that insured against default. AIG’s financial product division irrationally failed to track the proportion of subprime mortgages in the pools being insured, thereby misgauging the risk of those assets and causing the associated CDS to be mispriced. Interestingly, this failure occurred despite incentives that balanced long-term performance against short-term performance. Moreover, conversations that AIG had with its trading partners indicate the presence of a widespread conservatism bias regarding the assumption that historical mortgage default rates would continue to apply.

Similarly, the UBS investment banking division admitted to misgauging subprime mortgage risk by not “looking through" the CDO structures and by assuming that historical default rates would continue to apply. UBS’s underperformance relative to competitors led them to exhibit reference point–induced risk seeking. This behavior was compounded by poor incentive structures at UBS that emphasized short-term performance over long-term performance.

Recall that UBS placed no operational limits on the size of its CDO warehouse. It was not alone. Investment banks are typically intermediaries, not end investors planning to hold large positions in subprime mortgages. Some hold the equity tranches of CDOs as a signal to the buyers of the less risky tranches. What created many of the losses for investment banks, however, was inventory risk—risk stemming from warehousing the subprime positions that underlay CDOs. As the housing market fell into decline, many investment banks found that they could not find buyers for the CDOs and, as a result, inadvertently became end investors.

The rating agencies and investors’ reliance on them played a huge role in the financial crisis. Both (supposedly) sophisticated investors, such as the investment bankers at UBS, and naive end investors, such as the Narvik town council, relied on the risk assessments of rating agencies. The rating agencies, however, explicitly indicated that their ratings were premised on accepting the information they received as accurate, even if the mortgages featured limited documentation. For this reason, the agencies suggested that their ratings be treated as only one piece of information when assessing risk. By this argument, users who accepted their ratings at face value behaved irrationally.

Did the rating agencies exhibit irrational behavior by weakening their risk assessment criteria to cultivate more business? This question is different from asking whether the ratings agencies behaved ethically. The major problem with the behavior of rating agencies might arise more from a conflict of interests (the principal–agent conflict) than irrationality, in the sense that the issuers of securities, not the end investors in the securities, pay for ratings. Still, the evidence suggests that reference point–induced risk seeking and groupthink were issues at S&P.

In addition to the five entities highlighted here, many others participated in the financial product supply chain. For example, press coverage suggests that the value-destructive dynamics at UBS were also at work at other financial institutions active in initiating subprime mortgages and in creating CDOs that included subprime mortgages (see Shefrin 2009).

In 2004 and 2005, the activities of these financial institutions might have been rational because they were able to shift default risk to AIG by purchasing CDS. Lewis (2009) quoted AIG employees as stating that their firm’s willingness to sell CDS allowed the CDO market to grow at a rapid rate. After AIG stopped selling CDS, however, many financial firms took on the risk themselves, apparently under the illusion that housing prices would continue to rise and that default rates would not be affected by the increased ratio of subprime to prime mortgages. At one point, Merrill Lynch used CDS to create synthetic CDOs because the number of subprime mortgages available to create traditional CDOs was insufficient relative to the firm’s aspirations.

The financial crisis also raises issues involving being “too big to fail" and moral hazard. Some might argue that the root of the financial crisis was a rational response by executives of large financial institutions to the perception that they could take on excessive risk because the U.S. government would intervene should those risks prove disastrous. To be sure, the executives must have been aware of such a possibility. The management failures at these institutions bore the telltale signs, however, of psychological pitfalls. In addition, a sign that intervention was not guaranteed came with the government’s choice to let Lehman Brothers fail.

Not only was the SEC subject to confirmation bias, but I believe overconfidence might have pervaded the entire regulatory landscape. Consider the comments of Alan Greenspan, who chaired the Federal Reserve during the key years in which the seeds of the crisis were sown. In June 2005, Greenspan testified before Congress that some local housing markets exhibited “froth." He pointed to the use of risky financing by some homeowners and suggested that the price increases in those local markets were unsustainable. He concluded, however, that there was no national housing bubble and that the economy was not at risk.20 In the same vein, Greenspan’s successor at the Fed, Ben Bernanke, gave a speech on 17 May 2007 in which he stated, “[W]e do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system."21

In 2008, Greenspan testified before the House of Representatives Committee on Oversight and Government Reform as follows:

[T]his crisis, however, has turned out to be much broader than anything I could have imagined . . . . Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked disbelief. (Felsenthal 2008)

Consider the behavioral issues raised by Greenspan’s comment about self-interest. Lending institutions are not masochists. The behavioral point is that psychological pitfalls created a gap between perceived self-interest and objective self-interest, thereby inducing irrational decisions.

Most parties involved in the financial crisis are asking what they can learn from the experience. Under the leadership of the SEC’s new enforcement chief, Robert Khuzami, the SEC is instituting a series of new procedures, such as providing senior enforcement officers the power to issue subpoenas without requesting permission from commissioners. UBS has created a presentation titled “Risk Management and Controls at UBS." The presentation emphasizes that managers must pay explicit attention to a series of behavioral issues, such as irrational exuberance in asset pricing.

These steps are in the right direction. A body of academic literature describes how organizations can take steps to avoid behavioral pitfalls (see Heath, Larrick, and Klayman 1998), but dealing with psychological pitfalls is not easy. The application of behavioral corporate finance and behavioral asset-pricing theory is not yet widespread. Moreover, little evidence indicates that organizations have developed systematic procedures along these lines.

The most useful behavioral lessons we can learn from the crisis are how to restructure processes to incorporate the explicit elements of behavioral corporate finance that this article has discussed. I have suggested that to avoid the kinds of process weaknesses exemplified by the five cases described here, systematic procedures within organizations should focus on the four key organizational processes listed in Exhibit 1: planning, standards, information sharing, and incentives (Shefrin 2008b).22 Checklists are no panacea, but they do make the issue of vulnerability an explicit agenda item.

Still, the removal of psychological biases is not easy. Psychological pitfalls are likely to persist and to continue to affect decisions. For this reason, managers, analysts, investors and regulators would be well advised to keep three main points in mind. First, sentiment can affect asset pricing, particularly pricing of the securities of companies followed by analysts. Second, corporate managers are vulnerable to psychological biases (as we all are); therefore, these pitfalls are germane to companies’ operational risks. Third, analysts themselves are vulnerable to psychological pitfalls and need to be mindful of how these pitfalls affect their own processes and decisions.

For example, consider what analysts might have missed about Citigroup before October 2007. Were Citigroup and AIG connected? In this regard, consider the CDS deals that AIGFP did in 2004 and 2005. Lewis (2009) quoted an AIGFP trader as saying, “We were doing every single deal with every single Wall Street firm, except Citigroup. Citigroup decided it liked the risk and kept it on their books. We took all the rest." (p. 1).

This remark should hold a lesson for analysts about applying tools from behavioral corporate finance. For example, analysts might use the framework encapsulated by Exhibit 1 to focus on the combination of process and psychological pitfalls in a situation. In the case of Citigroup, analysts could have focused on Citigroup’s planning process in late 2004 and early 2005, when it was dealing with flagging profit growth. In that situation, Citigroup would have been especially vulnerable to reference point–based risk seeking. Indeed, Citigroup’s board did decide to increase the firm’s risk exposure after a presentation from a consultant, thereby taking a path similar to that of UBS.

Although analysts have no direct access to boardroom discussions, keeping the quality of governance in mind can be worthwhile. Consider whether Citigroup’s board exhibited groupthink. In a Wall Street Journal article about Citigroup board member Robert Rubin, Brown and Enrich (2008) stated, “Colleagues deferred to him, as the only board member with experience as a trader or risk manager. ‘I knew what a CDO was,’ Mr. Rubin said" (p. 1).

As the cases discussed in this chapter attest, assuming that financial institutions will make intelligent, bias-free risk–reward decisions is a mistake. Looking back after the crisis unfolded, Brown and Enrich (2008) quoted Rubin as saying about Citigroup’s decision to take on more risk, “It gave room to do more, assuming you’re doing intelligent risk–reward decisions" (p. 1). Learning that decision makers have psychological biases is an important lesson, not just for analysts but for everyone. Moreover, the lesson applies at all times, a point to keep in mind even as economic conditions improve and the financial crisis that erupted in 2007–2008 fades into memory.

–Hersh Shefrin

Mario L. Belotti Professor of Finance Santa Clara University Santa Clara, California Forthcoming in Voices of Wisdom: Understanding the Global Financial Crisis. Edited by Laurence B. Siegel. Charlottesville, VA: Research Foundation of CFA Institute.

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16 An audio file of the relevant portion of the SEC meeting is available at Transcripts of open meetings of the SEC can be accessed at

17 The audio contains information (especially about what the laughter signifies) that does not come across in the written transcript. In the first instance, the laughter comes as a response to the contrast between Goldschmid’s remark about trusting staff and his question, including tone of voice, about the staff being capable of performing the task. The second instance of laughter comes in response to Mike’s humorous statement that he will not be doing the task alone. Notably, he is serious when he describes the resources he envisages being allocated to the task. In my view, the group laughter in the second instance does not reflect doubt that the SEC staff was capable of performing the task or doubt that the resources described were woefully inadequate.

18 The SEC’s internal report rejects the possibility that political influence played a part in the SEC’s failure to detect the Madoff fraud. Rather, it focuses the blame squarely on the judgment calls of agency investigators and staff.

19 The person Nocera quoted is John A. Sten, a former SEC lawyer who represented a former Morgan Stanley broker whom the SEC prosecuted unsuccessfully for almost a decade.

20 Under Greenspan, in the recession that followed the bursting of the dot-com bubble, the Federal Reserve cut interest rates to 1 percent. Some have criticized the Fed for keeping interest rates too low for too long, thereby encouraging the dramatic increase in mortgage volume. See

21 The speech was given at the Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and Competition held in Chicago. See

22 Only a thumbnail sketch of the approach can be provided here; for the detailed approach, see Shefrin (2008b).


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