The financial crisis: moral failure or cognitive failure?

• Author: Kling, Arnold
• Position: Movie review - Company overview

This may be our first epistemologically-driven depression. (Epistemology is the branch of philosophy that deals with the nature and limits of knowledge, with how we know what we think we know.) That is, a large role was played by the failure of the private and corporate actors to understand what they were doing. Most heads of ailing or deceased financial institutions did not comprehend the degree of risk and exposure entailed by the dealings of their underlings--and many investors, including municipalities and pension funds, bought financial instruments without understanding the risks involved. (1)

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There are two major competing narratives for the financial crisis. One narrative focuses on moral failure, in which the compensation structure for executives at financial institutions encouraged them to place their own and other firms at risk to reap short-term gains. (2) The other narrative focuses on cognitive failure, in which executives and regulators overestimated the risk-mitigating effects of quantitative modeling and financial engineering. It is important to sort out which of these narratives deserves more credence.

Those who emphasize moral failure have highlighted a number of distortions between private and social benefits, including: that executive pay at financial institutions is not tied to long term viability, (3) the "originate to distribute" model of mortgage financing gives the originator an incentive to make bad loans that are passed down the line in the system of structured financing of mortgage securities, (4) and rating agencies are overly generous in granting AAA and AA ratings because they were paid by the issuers of mortgage-related securities. (5)

Under the moral failure theory, the essential problem is the misalignment between the incentives of executives to maximize their own salaries and the long-term best interest of the financial firms they led. (6) In this narrative, regulators were either stifled by ideological faith in markets or hampered by organizational flaws--most notably, the alleged absence of anyone charged with monitoring systemic risk.

The other narrative is one of cognitive failure. Under this view, key individuals believed propositions that turned out to be untrue. Propositions that were falsely believed included: that a nationwide decline in housing prices, having not occurred since the Great Depression, was impossible; increased home ownership rates were a sign of economic health; the use of structured finance and credit derivatives had reduced risk to key financial institutions; monetary policy only needed to focus on overall economic performance, not on asset bubbles; banks were well capitalized; and quantitative risk models provided reliable information on the soundness of mortgage-backed securities and of the institutions holding such securities. (7) In hindsight, these propositions were wrong. Policymakers were caught up in the same cognitive environment as financial executives. Market mistakes went unchecked not because regulators lacked the will or the institutional structure with which to regulate, but because they shared with the financial executives the same illusions and false assumptions.

Under the narrative of moral failure, the financial crisis was like a fire started by delinquent teenagers, with the adults in charge not sufficiently inclined or positioned to exercise adequate supervision. The solution is thus to reorganize and reenergize the regulatory apparatus.

Under the narrative of cognitive failure, it is as if the authorities supplied the lighter fluid, matches, and newspapers used to start the fire. In particular, housing policy encouraged too many households to obtain homes with too little equity. Bank capital regulations steered banks away from traditional lending toward securitization. Moreover, these regulations encouraged the banks' use of ratings agencies and off-balance-sheet entities to minimize the capital held to back risky investments. If this narrative holds, then financial regulation itself is inherently problematic. Regulators, sharing the same cognitive environment as financial industry executives, are unlikely to be able to distinguish evolutionary changes that are dangerous from those that are benign. It may not be possible to design a foolproof regulatory system.

1. FREDDIE MAC

   Perhaps the best illustration of the tension between moral and cognitive failure narratives is the response to Freddie Mac's rapid decline. Freddie Mac, a company chartered by the government in 1970 but sold to private investors in 1989, was one of the institutions that suffered catastrophic losses, in part because it relaxed credit standards from 2002 through 2007. (8) Was this relaxation a moral or cognitive failure?

   In August 2008, the New York Times reported that in deciding to become more active in the subprime mortgage market, Freddie Mac's CEO, Richard Syron, had ignored the warnings of the company's Chief Risk Officer, David andrukonis. (9) Early in 2004, Andrukonis had sent Syron memoranda that argued against purchasing mortgages that were originated with reduced documentation. (10) Shortly afterward, Andrukonis left, and Freddie Mac expanded its purchases of various high-risk mortgage products. (11)

   The narrative of moral failure would suggest that Syron was motivated by the desire for short-term profits and bonus payments to the detriment of his obligations to shareholders and other long-term constituencies. Certain reports, however, such as one that appeared in the Boston Globe, (12) paint a different picture. According to this alternative account, Syron focused on his responsibility to keep Freddie Mac active in a mortgage market that was shifting away from traditional safe mortgages and toward riskier products. (13) Moreover, he believed that Freddie Mac had a mission to serve the needs of minorities and low-income home buyers. (14) One could therefore argue that his decisions were driven by moral considerations, not by personal greed.

   The ultimate...