Bryan Caplan  

Intelligence, Common Sense, and Subprime

John Allison's Nice Summary... Henderson on Milton Friedman...
Conjecture: Financial experts' strange combination of astute calculation and elementary error on subprime lending is one of history's most important examples of the contrast between intelligence and common sense.


COMMENTS (12 to date)
Matt H writes:

Hindsight bias!

Matthew G writes:

But is there recorded evidence that agents exercising "common sense" reached accurate judgements as to the probability of home price declines?

Memory is malleable, and hindsight bias can be overwhelming. Continued price appreciation appears to violate our current notions of common sense, but of course, this common sense is conditioned on having observed the subprime meltdown.


A simple model that rationalizes observed facts is that market participants believed, incorrectly, that home rental rights would dramatically increase in the future. Clearly, this was wrong, but I don't see much evidence that people using "common sense" got it right.

Tom West writes:

Strong disagreement here - it's common sense that running in the opposite direction to the rest of the crowd will only get you trampled first.

The best most can do is quietly exit the industry and hope you have skills and credentials that can be used elsewhere.

James A. Donald writes:

You, Bryan Caplan and your equally pious commenters, are all ignoring the elephant in the living room, which is race.

The fundamental theory underlying extraordinary housing appreciation was that gigantic hordes of Mestizos were buying houses in green leafy suburbs and were becoming middle class, were going to get middle class jobs that would enable them to pay off those very expensive houses.

To doubt this was to suggest that Mestizos are genetically low IQ and doomed to remain underclass for generation after generation. So no one could possibly doubt this.

Thus, for example, the Bank of Beverly Hills failed to make no money down mortgages available for people with no job, no income, no assets, and no credit rating. The regulators deemed the Bank of Beverly Hills racist for this tight fistedness, so, to redeem itself for its horrible sinful racism it agreed to make lots of easy money loans available to people of a particular race, and, of course, went bust.

Racism. Racism. Race.

OneEyedMan writes:

Many of these people where paid in ways that required them to be long the housing market professionally. While it would have been possible to pretend to believe this was a good idea while doing otherwise privately, sincerity is difficult to fake. People who earnestly believe in improbable odds of ever higher prices are going to be more effective than fakers at advocating deals and sales associated with the housing boom.

If I recall correctly, evolutionary biologists have made similar arguments for the function of love, saying that partners that sincerely love each other will do better at conveying their investment in the long term relationships than fakers would. Even though the same actions are available in both situations, sincerely provides a more effective signal of future intentions and so we have evolved mechanisms to detect sincerity.

Eric Falkenstein writes:

everyone thought housing was a free lunch back in 2006: investors, regulators, legislators, academics, individual home buyers. All had theory and data to support them. Ex post, this was clearly all flawed, tendentious support. Interestingly, it pervaded the White House, Harvard, Countrywide, and Main Street to the same degree. As Larry Summers noted, it was all based on the idea that in aggregate, US housing prices don't fall.

So, I don't think the distinction of intelligence and common sense is particularly relevant here.

Ken B writes:

Most of my friends, and I, avoided huge mortgages on homes we could not afford. This was clearly a foolish decision. Common sense would have told us to exploit bankruptcy law and political power to the hilt, as did wiser souls.

Hana writes:

The housing bubble was a confluence of multiple factors. While the subprime loan mess is one of the factors an additional factor was the tax code, still existing, which allows the $500k allowance for capital gains on residences for couples.

Many couples I know in the bay area also owned homes in the central valley, (Tracy, Stockton, Vallejo, Lathrop). They purchased,with small amounts down, and sold these houses and captured the capital gains. In some cases, they took second mortgages out in lieu of selling the house. If you were to visit these 'second' houses you would see photos, furniture and all of the trappings of a lived in house. But they weren't. It was purely an investment strategy, supported by the tax code, of the investors.

On a small level, these investments have persisted. While they do not explain the bubble, they are one consequence of the factors leading up to it.

Doug writes:

It's not so simple as saying that financial experts thought housing could never go down.

If it was that simple banks would have never bothered to tranche mortgages in securitized pools in the first place. A mortgage isn't a direct bet on the value of a house. It's a bet on whether the homeowner will default and if he does what the recovery value will be. (Along with interest rate exposure, pre-payment speed, etc.)

The value of tranches are derivatives on the correlation of loan losses in the pool. Even if housing declines (sparking higher default rates) the credit support in a CDO protects the senior tranches.

Banks were largely betting that correlation of mortgage defaults and losses was very unlikely to rise above historical levels. This bet is a lot less of "obviously stupid belief" than thinking that housing would never decline.

It is true that a decline in housing caused these pools to take massive losses. But this wasn't a necessary consequence of falling home prices. The speed and severity of the defaults were much higher than many could have anticipated even given a housing bear market.

It was a combination of falling home prices along with a very severed recession, frozen credit markets, a slow and weak monetary policy response and unprecedented consumer de-leveraging.

One of my pet theories is that academics are most likely to go awry when they attempt to use the common sense they don't have. As long as they stick to academic reasoning they're okay.

Steve Sailer writes:

Angelo Mozilo announced repeatedly that Countrywide, the biggest and most ambitious mortgage firm, was going all in on minority lending, that Hispanics had been underserved just as Clinton HUD secretary (and now Countrywide director) Henry Cisneros had told him in 1994.

It's hard to imagine a more scientifically valuable natural experiment than publicly Mozilo betting his company on Hispanics. A large number of studies on defaults have been published by economists since 2010 and they all coincide with Mozilo was telling us in 2003-2005: lenders were betting huge on the expanding Hispanic market.

Glen S. McGhee writes:

I think Falkenstein gives good reasons for holding that intelligence is not a helpful category of explanation. Assuming that intelligence is cognitive, the 'cognitive footprint' (to coin a phrase) of those involved in the housing bubble was determinative of outcomes. I agree with Falkenstein.

This also applies to common sense. You cannot think about something that no one else is thinking about, at least, not to any great extent. Cognition is a social characteristic, as is denial in all its forms.

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