Subprime Crisis What Went Wrong - Maury Seldin

The approach advocated is a strategic approach; one that recognizes that there is uncertainty and that there is a chance that the decisions that we will make will be in error. The strategic approach recognizes that human beings see the world from many different perspectives and as a result, do not always make decisions in a way the others see as logical. There is always uncertainty as to how others will react to stimuli and the actions that they will take in response to those stimuli. Behavioral economics is an emerging field that recognizes that “logic” varies widely from person to person. Indeed, some “illogical” actions may be a reaction to one’s own decisions. By so-doing, one may constrain the loss from being wrong. To paraphrase Josh Billings, it is not so much what we don’t know that gets us in trouble, as it is what we think we know that turns out to be wrong.

With that in mind, I will share what I think I know that will help in enhancing understanding of the subprime debacle and hope that others will carry it forward or substitute better analyses. Please read the main essay, Subprime Crisis Strategic Decision Making: A Discussion of What Went Wrong and Strategies to Deal With It and send in your comments.

An explanation of the origins of the subprime debacle could start in many places. My choice is to develop a readily understandable line of reasoning that focuses on two ideas. One is wealth creation and destruction. The other is on participants’ perspectives and decisions. By blending those two themes we can look at the debacle as starting with an unsustainable rise in house prices facilitated by less than prudent mortgage finance.

The next stage in the development of the line of reasoning is to consider the wealth destruction facilitated by the mortgage finance innovations, and their abuse, in the capital market. The destruction of wealth resulting from that fiasco reverberated to the rest of the capital market.

The next stage of the line of reasoning is the freezing up of capital markets and government intervention. The rescue plan, nee bail-out, was the first of a series of dramatic changes in the philosophical approach to the issues.

Please read the main essay, Subprime Crisis Strategic Decision Making: A Discussion of What Went Wrong and Strategies to Deal With It and send in your comments.

The Housing Problem and the Economic Crisis - Robert H. Edelstein

"It is clear that the larger financial and economic crisis cannot be resolved without stabilizing and addressing key issues surrounding the housing market, in general and foreclosures in particular. A solution to the mortgage/home price/foreclosure problems will likely engender stabilizing forces for other critical sectors of the economy. In this paper, we evaluate all the major, existing housing and mortgage related policy proposals, while applying our benchmark criteria of i) future mitigation of moral hazard, ii) bang for the buck, iii) fairness and distributive aspects, and iv) judicious mix of short-term and long term solutions. Going forward, several factors will be important for fostering stability in the housing and residential finance markets:

1. A sustainable, viable plan is likely to require elements of a standardized approach (e.g. for interest rate reduction), as well as triage for case-by-case loan modifications.

2. Losses and gains may have to be shared among three parties: lenders, borrowers and Government.

3. Legal reform may be necessary in order to delink servicers from security investors and clear the way for refinancing.

4. Targeting home-buying assistance to geographic areas with high foreclosure rates would bring the support directly to neighborhoods most in need of housing market stabilization.

5. There is little data on "jingle mail" share of foreclosures and on investor-landlords. A method for addressing these homes, perhaps tied to rental assistance, could keep the homes occupied and off the market.

6. An overhaul, restructuring and redistribution of federal and state regulatory responsibilities might combine the best institutional features of both."

Psychological Perspective of Standard Economics - by Jack Lillibridge

My focus is on the following quote from the essay, Subprime Crisis Strategic Decision Making: A Discussion of What Went Wrong and Strategies to Deal With It "There is always uncertainty as to how others will react to stimuli and the actions that they will take in response to those stimuli. Behavioral economics is an emerging field that recognizes that "logic" varies widely from person to person."


This blog comment, linked to my summary of my presentation at the Seminar on Strategic decision Making, is an abridged version of my presentation of comments on some books relevant to how concepts from psychological economics may contribute to understanding the current economic situation and what might be done about it. My presentation focused on three books; Predictability Irrational: The Hidden Forces that Shape Our Decisions by Dan Ariely; The Mind of the Market: How Biology and Psychology Shape Our Economic Lives by Michael Shermer; and Nudge: Improving Decisions About Health, Wealth and Happiness by Richard Thaler & Cass Sunstein.


Psychological Perspective of Standard Economics - By Jack Lillibridge

In my blog comments on Psychological Perspective of Standard Economics built on my presentation for the Seminar on Strategic Decisions I explored how the theory of complex adaptive systems might suggest ideas to help us understand the current economic crisis, how it happened, possible key causal variables, and likely outcomes.

A central idea from the theory is that complex systems, such as the economic system, have a dual nature: a stability aspect and a growth aspect. The stability aspect is characterized by balance, continuity, equilibrium, renewal, etc., and the growth aspect is characterized by creativity, learning, exploration, risking, etc. A human being has a similar dual nature: a stability aspect to insure survival and a growth aspect to deal with unexpected challenges and anticipated needs.

The three books: Predictably Irrational by Dan Ariely, Nudge by Richard Thaler and Cass Sunstein, and The Mind of the Market by Michael Shermer, present and illustrate psychological factors that may influence economic decisions in ways not accounted for in the standard economic model.

Nudge also describes many examples of a general strategy that may improve such economic decisions. The strategy structures the array of decision options of an economic actor in such a way as to make choosing the most beneficial option more likely without restricting free choice.

A brief recap of some of the psychological factors:
o Anchoring is where first impressions and initial decisions shape many others that follow. Once an initial value or percept is set, we are biased toward that original choice.
o Status quo bias is exhibited as a kind of inertia when making decisions. We opt for what we are used to.
o Loss aversion is where people fear losses more than they desire gains.
o When something is free we forget the downside. We perceive what is being offered as being much more valuable than it really is.
o An automatic pilot mode is where people are not actively paying attention to the task at hand.
o A variation of this is where people rely on beliefs, heuristics, models, theories,
etc. without paying attention to whether they are still appropriate in the current situation.

There are many other psychological factors that might be relevant, such as expectations, short-sightedness, self-justification, curiosity, etc., not explicitly dealt with in the books reviewed. Please see essay for further detail.

Posted by Maury Seldin on behalf of Jack Lillibridge. The comment was prepared prior to blog opening and the link is to an essay prepared by Dr. Lillibridge for Maury’s seminar at ASPEC.’ Dr. Lillibridge has his Ph.D. in Psychology.