By Karl Smith, Contributor From Jim Hamilton: One interpretation emphasizes misaligned incentives. Money managers earned bonuses while others were left holding the bag. Institutions like Fannie, Freddie, and AIG profited handsomely during the run-up, but the government picked up the tab when things went bad. These kinds of explanations come very naturally to most economists, whose models are usually built on the assumption that economic decision-makers are responding in a rational way to the incentives they face. But an alternative view is that the key players were simply mistaken as a group, lulled into a misunderstanding of what was going on through social and institutional feedback that sustained a misguided groupthink. This view is hard for many economists to embrace, though there is a good case to be made that this is an important part of the story of what we just went through. The “groupthink” story is very close to my preferred story. My preferred stories, however, is even less perverse. My story essentially turns on the idea that if all of your friends jump of the Brooklyn Bridge, then yes you jump the Brooklyn Bridge – or start securitizing subprime loans, as the case may be. Telling this story induces so much backlash that I typically just tell an incentive story unless financial reform itself is the core issue we are discussing. Jim links to evidence that is both powerful and easy to understand. The folks making tons of money selling subprime mortgages and creating a housing bubble, bought more expensive houses. Not, just because they were richer but, it seems because they believed in housing: Our analysis shows little evidence of securitization agents’ awareness of a housing bubble and impending crash in their own home transactions. Securitization agents neither managed to time the market nor exhibited cautiousness in their home transactions. They increased, rather than decreased, their housing exposure during the boom period through second home purchases and swaps into more expensive homes. This difference is not explained by differences in financing terms such as interest rates, or refinancing activity, and is more pronounced in the relatively bubblier Southern California region compared to the New York metro region. Our securitization agents’ overall home portfolio performance was significantly worse than that of control groups. Agents working on the sell-side and for firms which had poor stock price performance through the crisis did particularly poorly themselves. Mistakes Were Made. Is it possible that in a world of spontaneous-order and design-without-a-designer, that there are also spontaneous-errors and mistakes-without-a mistaker? Stranger things, you know. …read more
Source: FULL ARTICLE at Forbes Latest