The Giant Pool of Money Case Analysis
The Issues
The radio program draws an overall picture of the subprime mortgage crisis, how the subprime market was created, how the crisis happened, what were the result and its impact. (See appendix A - my summary of the case)
The primary issues in this case are: why did the Wall Street bankers blindly trust that the risky mortgages were good assets to invest into? And why did everyone involved allow the whole thing to go this far?
The Analysis
The Wall Street bankers ignored the fact that the mortgages were risky is mainly due to the confirmation bias, specifically, the Anchoring Heuristic.
Bazerman and Moore’s (2009) defines the Anchoring Heuristic as “Individuals make estimates for values based upon an initial value (derived from past events, random assignment, or whatever information is available) and typically make insufficient adjustments from that anchor when establishing a final value”.
It was exactly what Mike Francis did when he made the decision to invest in the mortgages-backed securities. Facing the pressure to find new types of investment for the investors, he looked into the historical data of mortgages, and concluded that because the no income loans existed so far performed well, they would not have much risk in the future. His reasoning was flawed. The historical data set him the wrong perception and it anchored in his mind. Bazerman and Moore further argue that people tend to think that the subsequent information is in consistency with the preexisted anchor (Bazerman & Moore 2009). Therefore, Mike never went back to reevaluate his decision. The reality is, according to Davidson (Blumberg & Davidson, 2008), the mortgage has much higher foreclosure rates than Mike’s impression and prediction.
Another anchor was made by the credit rating agencies like Moody’s. They gave AAA rating to the risky mortgage-backed securities based on the incorrect data. The anchor was that the investors trusted their ratings, as they typically do.
The radio program draws an overall picture of the subprime mortgage crisis, how the subprime market was created, how the crisis happened, what were the result and its impact. (See appendix A - my summary of the case)
The primary issues in this case are: why did the Wall Street bankers blindly trust that the risky mortgages were good assets to invest into? And why did everyone involved allow the whole thing to go this far?
The Analysis
The Wall Street bankers ignored the fact that the mortgages were risky is mainly due to the confirmation bias, specifically, the Anchoring Heuristic.
Bazerman and Moore’s (2009) defines the Anchoring Heuristic as “Individuals make estimates for values based upon an initial value (derived from past events, random assignment, or whatever information is available) and typically make insufficient adjustments from that anchor when establishing a final value”.
It was exactly what Mike Francis did when he made the decision to invest in the mortgages-backed securities. Facing the pressure to find new types of investment for the investors, he looked into the historical data of mortgages, and concluded that because the no income loans existed so far performed well, they would not have much risk in the future. His reasoning was flawed. The historical data set him the wrong perception and it anchored in his mind. Bazerman and Moore further argue that people tend to think that the subsequent information is in consistency with the preexisted anchor (Bazerman & Moore 2009). Therefore, Mike never went back to reevaluate his decision. The reality is, according to Davidson (Blumberg & Davidson, 2008), the mortgage has much higher foreclosure rates than Mike’s impression and prediction.
Another anchor was made by the credit rating agencies like Moody’s. They gave AAA rating to the risky mortgage-backed securities based on the incorrect data. The anchor was that the investors trusted their ratings, as they typically do.
References: • Blumberg, A., & Davidson, A. (2008, May 9). The giant pool of money. This American Life radio program. Retrieved from http://tinyurl.com/MGMT409GiantPool • Bazerman, M. H. & Moore, D. A. (2009). Common biases. Chapter 2 of Judgment in Managerial Decision Making. New York: John Wiley & Sons. Read pages 14-33 and 36-41 (i.e., skip bias 10). • Bazerman, M. H. & Neale, M. A. (1992). The irrational escalation of commitment. Chapter 2 of Negotiating Rationally. New York: Free Press.