Arnold Kling  

Cognitive Failure or Moral Failure

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Claire A. Hill writes,

many brilliant and sophisticated market participants with considerable amounts of money at stake and considerable access to information about the securities and about markets generally made the same mistake the rating agencies did. These instruments were not bought by widows and orphans who might more reasonably have unquestioningly relied on rating agency ratings. Moreover, many of the market participants involved had previously expressed some skepticism about the savvy of rating agencies.

Of course, there was one important player who took agency ratings on faith. The regulators based capital requirements strictly on agency ratings.

Still, I agree with the thrust of her piece, which is that the problem at the rating agencies was a cognitive failure more than a moral failure. They, along with everyone else, believed in the magic of securitization and innovative risk management. I have a forthcoming article in the Harvard Journal of Law and Public Policy on the issue of cognitive failure and moral failure.

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COMMENTS (17 to date)
Alex J. writes:

Why were people put in charge of things about which they had cognitive failures? We have processes for making sure your dentist, say, doesn't have much in the way of cognitive failures regarding dentistry (though I recall Caplan's marginal tooth). One hopes that CEOs suffering from suit-geek divide would get sniffed out by the stockholders or bondholders. Investors would steer clear of areas in which they are not suited to evaluate the risks. Hard to evaluate sectors should be relatively impoverished of capital. If not fools and their money get parted.

Congress and the fed are doing their best to not learn the lessons of the mortgage crisis. Ergo, all of the failings that led to the crisis were things that politicians wanted to occur. When congress demands that unworthy securities should be rated AAA, obviously one should doubt that such securities actual deserve the rating, but it also signals that congress might intervene to subsidize them.

roversaurus writes:

Maybe they just believed in the magic of bailouts?

Governments have been bailing out the bad investments of large banks for a very long time. Besides the most recent TARP and EURO-TARP wasn't the last one a bailout of Mexico?

Ted writes:

It's actually both a cognitive and moral failure, in my opinion.

The complexity of these products makes it very difficult to detect counterparty risk, what the sensitivity to the underlying valuation of the asset says about the riskiness of the product etc. I think the rating agencies simply didn't know how to rate these things correctly since it's very difficult to do (a cognitive failure), and so they rather corruptly took the banks words for it that these were "safe" (a moral failure, you shouldn't slap AAA on something you didn't understand).

The biggest problem with the rating agencies was that it gave investors a false sense of security, and so they no longer did their due diligence as investors. Perhaps if they had attempted to investigate these CDOs themselves rather than relying on rating agencies and what not they would have seen how difficult it is to assess the risk and would have been less likely to participate in the market, possibly preventing a meltdown of the financial sector when a recession came along.

Brian Clendinen writes:

I still think the best quote on the risk models they created for securitization default rates was something like ' It was like trying to predict Kansas weather using Miami’s historical weather data'. I will need to read the article but I think it was more moral due to the major conflicts of interest. They knowingly did not do there due diligence because of the huge fees they would not garnish in the future if they gave something a poor credit rating.

One solution would be the rating agencies would be required to pay back the fees plus interest to the side that was harmed. The criteria would be if default rates were significantly outside the rate they assigned (2 std. Dev). And yes they should give back fees to the issuer if the mortgages were significantly safer than they estimated.

Brian Clendinen writes:

I still think the best quote on the risk models they created for securitization default rates was something like ' It was like trying to predict Kansas weather using Miami’s historical weather data'. I will need to read the article but I think it was more moral due to the major conflicts of interest. They knowingly did not due there due diligence because of the huge fees they would not garnish in the future if they gave something a poor credit rating.

The solution would the rating agencies would be required to pay back the fees plus interest to the side that was harmed. The refund clause would be if the default rates were significantly outside the rate they assigned (2 std. Dev). And yes they should give back fees to the issuer if the mortgages were significantly safer than they estimated.

Carl The EconGuy writes:

I haven't read the paper yet, but I look forward to an explanation of why the rating agencies completely seem to have missed the ninja loans that the banks issued and the completely fantastical property valuations undertaken by bank agents eager to get loan origination fees. Behind the rating agencies lie failures at a lower level, and it seems to me that the rating agencies didn't do due diligence in uncovering these completely fraudulent behaviors at the grass roots. Yes, with more competition among rating agencies these problems might have been discovered earlier. But the banks did it, and even seem to have believed their own liars and lies, because they held on to a lot of very high risk mortgages rather than dump them on Bear Sterns and other crazy risk takers. But I think the rating agencies should have looked the increasingly sick and old horses they kept rating highly in the mouths a little more carefully. They and the low-levels scums, along with the regulators and Congress, bear a heavy responsibility, in my opinion -- at least that's the conclusion I've come to in my studies of this.

William Newman writes:

I think I would say something like "were too cavalier about" securitization and innovative risk management, not "believed in the magic." Or maybe something like "were complicit in unrealistic and inconsistent accounting treatment of securitization."

(And not *everyone* else. E.g., Tanta at Calculated Risk, RIP; or years of carping about Fannie and Freddie at the WSJ.)

The broader "believed in the magic" formulation suggests that none of the securitization townspeople had any clothes, that no significant fraction of securitization arrangements made business sense. That's a popular/populist position, and maybe you could make a solid academic case for that position. But it doesn't seem like good practice to just score a cheap point by alluding to it in a rhetorical flourish.

(somewhat similarly, though that photoshopped populist flourish was added by the staff at _Science_, not by the original authors)

I'm not trying to be a Pollyanna about the post-1990 financial innovations. I think a large fraction of them contributed to social harm, though not necessarily ignorant --- e.g., maneuvering to transfer risk to institutions like Fannie and Freddie, and to game regulatory inconsistencies related to securitized risk. But securitization seems to me like the Black-Scholes equation in the 1980s, or double-entry bookkeeping for the last century or more: fundamentally a useful and sound idea, and widely used for sensible things even during episodes when it's widely abused. That securitization gives you a new kind of rope to hang yourself with doesn't differentiate it from, say, accounting. And that securitization is systematically misused when the regulations and other governmental institutions are set up to treat it inconsistently doesn't differentiate it from accounting either.

Consider that the plainest vanilla accounting admits accidental goofiness like depreciating stuff over what turns out to be very much the wrong timescale, and intentional goofiness like misclassifying paying employees with stock options as not-a-cost. That doesn't justify ridiculing the general concept of accounting with phrases like "believed in the magic of accounting." Specific criticism like "believed that formally classifying stock option grants as cost-free made the cost go away" would probably be more useful.

Floccina writes:

2 points

1. Some of the people were too young and so although they knew they did not know on an emotional level because they had never seen it before.

2. Now they know and so the regulation is not really needed.

Colin K writes:

If the people in the ratings agencies were really so good at assessing risk, couldn't they make more money trading securities than rating them? Or do people work for them because its makes for a saner lifestyle than the rest of the Street?

SMU Cox MBA writes:

We just published an article on this -

AaronG writes:

@ Colin K

There are plenty of people who do work as credit analysts for fixed income portfolio managers. These people can and do "beat" the ratings agencies (e.g. notice that not all A+ rated bonds trade at the same credit spread. Market participants generally anticipate changes in credit ratings rather than the other way around.)

However, if you are hiring someone to manage a fixed income portfolio, the question arises how to assess the manager's performance and how to control the risks he is taking. As the person responsible for the investment of the funds, I hire a portfolio manager because I don't have the time and or skill to invest the funds myself. I can use ratings from the agency to control the amount of risk the manager takes (no more than x% of the portfolio can be in securities rated worse than BBB) or to build custom benchmarks, tuned to the level of credit risk in the portfolio, to guage his performance. Besides the regulatory requirements that many managers have to deal with, this is a major source of demand for agency ratings.

Mark writes:

Slightly off topic. James Pethokoukis has written a column titled Voters ignore avoided costs of bailouts. Here's an argument that is made by many supporters of the 2008-2009 bailouts (and the Euro-TARP as well):

The alternative -- letting Citigroup , American International Group and other financial institutions fail -- could have sent U.S. unemployment to 13 percent instead of 10 percent, Federal Reserve officials reckon. And rather than growing at 3-4 percent, the economy might still be shrinking. The cost of further output shrinkage and declining asset prices would easily have been in the trillions.
Avoiding that result hardly seems like a failure.
Do most economists believe that the current 9.9 percent unemployment rate would have been higher, perhaps 13 percent, if we had allowed the bankruptcy process take place? Do most economist believe that the current rate of GDP growth we are now enjoying would actually be negative without the bailouts?

On what basis are such estimates made? After all, President Obama says that the unemployment rate would be even higher than it is now had the February 2009 stimulus plan not passed. I suppose the same could be said, without fear of contradiction, of the stimulus plan passed in the Spring of 2008.

I understand that we can't verify these statements or disprove them in a laboratory. But is the consensus in favor of these bailouts and stimuli as large as many supporters suggest?

Just thought I'd ask the question since we might hear these arguments again in the near future.

Rebecca Burlingame writes:

In a sense it is hard to assign blame for what happened in the markets, because even though the wealth was not real, many people needed that wealth to make things happen in their lives which otherwise could not. People needed reassurance that it did not matter whether production was still a major part of developed economies, and it seemed securitization could provide that.

Steve Roth writes:

I hope (and actually expect) that you'll address the trickiest issue:

When is intentional (or un- or semiconsciously intentional) cognitive failure a moral failure?

Elvin writes:


I hate to be off topic, but Kid Dynamite blog lists some things that could be considered beneficial financial innovations in the last two decades:
- ETFs allow retail investors to trade ever more granular risks in a more controlled fashion
- Trading moving from 1/8ths to pennies--transaction costs are lower
- Data on investments is much easier because of the internet
- After-hours trading
What do you think? I'd include the rise of index funds and their integration into the ETFs.

Milton Recht writes:

To call it a cognitive failure, doesn't one have to show that prices of trades in a liquid market substantially deviated from fundamental value? An underwriter's CDO price based on models and ratings is a guess at the value of a market based price. In the case of CDOs, the guess was off the mark.

The financial crisis began because CDO collateral value (a type of market price) declined, requiring more collateral to fund overnight borrowing, which created the liquidity and solvency crises at Bear Stearns and Lehman. No cognitive failure here.

As equity market participants recognized that the booked par value of CDOs was higher than the market value, bank stocks such as Citi, tumbled, reflecting the lower value of bank assets, the need for more capital and the potential of insolvency. No cognitive failure here.

Additionally, initial investors in CDOs chose these investments because they promised a higher yield than the equivalently rated US Treasury security. Investors switched from US debt to CDOs because of a promised higher yield. Higher yields mean higher risk and were required by investors to switch to CDOs. If investors truly believed the CDOs were AAA and not more risky than US debt, they would not have wanted a higher yield from CDOs. No cognitive failure here.

I have not seen any analysis that says that the ex ante promised yields of CDOs was not commensurate with the higher expected risk at the time of investment.

Analysis after known losses does not reflect the investment world before the losses. It is easy to recognize a poor investment after it loses money. It is not so easy to recognize one before the losses occur.

No one claiming they saw the coming housing crisis and bubble is claiming they sold their home(s) before the downturn, rented and then bought an equivalent home at a lower price and pocketed the profit.

Investors without cognitive failure make investment mistakes. Why can't all the housing market investment just be a mistake without resorting to all kinds of cognitive, modeling and analytical failings?

is there really any surprise, that a bureaucratic, rigid regulatory scheme using the rating agencies did not reflect real world events? Doesn't that happen all the time with all regulatory agencies?

The future is always difficult to predict. Do we always need to blame someone or something for our inability to predict tomorrow's events?

George X writes:

a) My understanding was that the rating agencies all bestowed AAA status on the risky-mortgage junk because their customers (the banks buying the junk) wanted them to, because capital reserve regulations limited the banks to AAA investments. If somebody pays me a bunch of money to lie to them, and I lie to them, that doesn't constitute a cognitive or a moral failure on my part. Hollywood is based on that very dynamic (not just the actors: the accountants, too).

b) The regulators had to take those AAA ratings on faith: there were rules they had to follow. That's one common failing of bureaucrats: they're rule-bound, and don't get to use their discretion. The other common failing of bureaucrats is when they do get to use their discretion—then you end up with things like TARP.

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