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Josh Hamilton

Global Financial Crises

Bordo

A Glimpse into the Mind of a Crisis:

An Analysis of the Cognitive and Behavioral Phenomena behind the 2008 Financial Crisis

Financial crises are a long standing, oft repeated malignancy of economics, guaranteed to

strike even the strongest, healthiest of economies. Of course, the United States is no stranger to

financial crises. From the days of Alexander Hamilton and the fledgling National Bank to the

recent “Great Recession” of 2008, the United States has been through a substantial amount of

crises despite its reputation for economic prowess. As such, much time and energy is devoted to

analyzing these crises, probing at the causes, the implications, the players; delving into what

went wrong and what lessons can be taken away. To this end, much can be learned and indeed

much has been; policy is constantly evolving and growing to keep pace with the ever changing

global economic environment of today. However, the point of this paper will not be to rehash

generally why the mechanisms of financial crises propagated as they did, but rather specifically

to examine in depth the behavioral and cognitive motivations behind the pivotal events which

engendered the financial crisis of 2008 in the United States.

The typical story of the 2008 crisis involves a wide array of mistakes and imprudent

decisions throughout the financial sector, involving both private and government agents. The

problem is multifaceted in that there were multiple factors at play leading up to the climatic

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downfall in 2008. Perhaps the most prominent factor is the set of circumstances leading up to the

housing boom and subsequent bust, toppling the subprime mortgage market in 2007. With

interest rates abnormally low, speculation in the housing market was high, leading to the

formation of a bubble. There seemed to be an “irrational exuberance;” a notion the market would

keep going up and thus no one could lose (Holt 2009). As a result, mortgages were given out like

wildfire with little supervision or regulation. For a time, nearly anyone could receive a mortgage

regardless of their income, credit, or background. In fact, a term sprang up for a certain type of

mortgages nicknamed NINJA loans, which stood for “No Income, No Job or Assets.” These

subprime mortgages were then securitized and bundled into collateralized debt obligations

(CDOs) which were lauded for their ability to diversify risk as they were backed by a wide

variety of mortgages. Furthermore, issuers of these derivatives offered Credit Default Swaps,

insuring the investor against defaults. CDFs made the CDOs seem essentially risk free, however

it exposed the issuers to a crunch should large losses occur (Financial Crisis Inquiry Commission

2011). Unfortunately, that is exactly what happened. In the two years leading up to the crisis,

interest rates began to rise (Bordo 2008) which, coinciding with the rampant over speculation,

unwise loan practices, and poor oversight, led to a steep increase in debt defaults and ultimately

the bursting of the housing bubble in 2007.

Banks with significant amounts of assets in CDOs felt the shock and began to go

insolvent, leading to systemic strain as the value of banks assets deteriorated. The first major

event in a string of bailouts and crashes came about when investment bank Bear Stearns began to

feel pressure following the burst of the housing bubble. The Fed determined Bear was too

connected to be allowed to fail, reasoning a failure would bring down other financial institutions.

As such, the Fed brokered a deal with JP Morgan to rescue Bear and then cut the discount rate to

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boost liquidity (Brunnermeier 2009). Following the rescue of Bear Stearns, Freddie Mac and

Fannie Mae were also bailed out for similar reasons. Soon after, Lehman Brothers began to face

problems and while many expected another bail out, the Federal Reserve instead chose to let

them fail. The subsequent fall of Lehman Brothers triggered the global recession and economic

downturn in 2008 as banks all over the world felt the burden of Lehman’s liabilities. On top of

the damage done by contagion, confidence plummeted as many expected Lehman to be bailed

out. A lack of confidence led to runs and a decrease in lending, increasing strain on banks’

balance sheets. What followed was a string of banks and financial institutions facing insolvency

and needing a bailout, most notably including AIG, and ultimately resulting in hundreds of

billions of dollars spent on stimulus in the years to come. Clearly imprudent, short-sighted,

unwise decision making by agents throughout the economy played a central role in the

unfortunate series of events and circumstances surrounding the crisis of 2008, however the

question remains as to what led to this imprudence.

Ill-advised decisions drove many of the propagation mechanisms responsible for the

sequence of events in the crisis and for the most part, can be explained by various behavioral and

cognitive phenomena, namely herd behavior, the availability heuristic, and groupthink. Herd

behavior is the behavioral phenomenon where individuals faced with uncertainty will simply

mimic the actions of their peers, harking to how an animal follows the herd despite not knowing

where the herd is going or why they are going there. Put so simply, herding sounds irrational, a

behavior one would expect from an animal or maybe a person of an equal mental capacity.

However, not only is herding incredibly common, it can even be rational in some situations.

Consider a situation in which an individual shows up to a party to find everyone’s wearing a t-

shirt while he’s wearing a suit. Two possibilities are feasible, either everyone else forgot the

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dress code or he forgot the dress code. With a large amount of people, the latter is the more

likely possibility and thus the man should follow herding behavior and go change. Put more

quantitatively, imagine a situation where there are two urns, Red and Blue. Red is filled with two

red balls and one blue ball, while Blue is filled with two blue balls and one red ball. One of the

urns is chosen at random and a group of people is told to form a line, pull a ball from the urn,

place it back in the urn, and then announce their guess as to whether the urn in question is Red or

Blue. Note, the ball pulled is private information while the guess is public. So say the first person

steps up, pulls a red ball and guesses Red (the math works out such that Red is more likely than

Blue given a sample of red.) Then say the second person steps up, pulls a red as well, and

guesses Red accordingly (note: if he pulled blue, both urns would be equally likely, but presume

he would guess Red in that case as well.) Now the third person steps up and knowing that the

first two guessed Red, he infers they must have pulled red and now guesses Red regardless of

what he pulls. The rest of the people in the group follow suit by the same logic and thus starts an

information cascade in which everyone guesses Red and herding becomes the rational choice.

Notice that even if every person pulled blue after the first two pulled red, the same outcome will

occur. Thus while herding can be understandable and even rational at times, it frequently can

lead to the wrong decision and in the context of agents making investment decisions, this can

have devastating effects.

Another way in which an individual might make a quick rational decision and come to

the wrong conclusion is by relying on the availability heuristic. The availability heuristic is a

mental shortcut where an individual determines the probability and likelihood of an event by

how easily instances of the event come to mind. For example, the number of airline tickets

purchased fell dramatically following the terror attacks on September 11th (Bureau of

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Transportation Statistics 2005). The availability heuristic would suggest the events of September

11th were so vivid and memorable that people concluded terror attacks on planes were more

likely than before, leading them to plan alternate routes. The veracity of these claims is a topic

for another paper; what’s important is that there’s some logic to the availability heuristic, albeit

an overly simplifying, “gut based” logic. In a less complex situation, the availability bias may be

stronger and more rational. Say for example, it’s the beginning of winter and a man remembers

vividly all the times last winter his driveway froze over and he ended up being late to work.

Remembering these incidents, he feels the chances of it icing over again this year are high so he

goes to the store and purchases rock salt. In this case, his decision was valid and rational since a

driveway icing over sometime during the winter is a fairly likely event. That said, it is also

entirely possible it turns out this year is predicted to be the warmest winter on record. In this

case, the availability heuristic led the man to make a seemingly smart decision, but in the end it

turns out he wasted his money since he didn’t do enough research. This examples demonstrates

the strength and weakness of the availability heuristic; he didn’t need to waste time and energy

on research to determine the frequency of the event with a degree of accuracy, but in doing so he

missed out on an important piece of information. To this end, the availability heuristic can lead

to critical errors if used by agents involved in investing, determining policy, deciding whether or

not to withdraw savings, etc. thus playing a crucial role in the events which unfolded during the

crisis of 2008.

Whereas the availability heuristic explains how an individual’s decisions can be led

astray, groupthink explains how an entire group can be led astray despite the misgivings of its

individual members. What transpires is a situation where an individual (or individuals) in a

group chooses to not voice their criticism of a flawed decision due to a sense of obligation to

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maintain unanimity and a fear of dissenting. What results is a failure to assess alternatives and

evaluate decisions properly, leading to critical errors in decision making as individuals actively

ignore new information signaling the flaws of the group’s decision. Summing up, strong decision

making breaks down when a group is under extreme pressure to make the right decision, when

there is fear of dissension, when there is an imbalance of power, and when a decision is

especially difficult. A classic illustrative example of groupthink can be seen in the tragic

Challenger explosion. On the day of the launch, NASA received word that a critical piece of the

shuttle was flawed and could lead to disaster given the abnormally cold weather conditions of the

launch day. However NASA had already postponed once due to weather and dismissed the

warning, feeling pressured to launch on schedule. The engineers responsible felt concerned and

chose to have a meeting, but unfortunately this meeting only lasted a few minutes. Under

pressure by the administration to green light the launch, they allowed Challenger to take off,

tragically resulting in the shuttle’s explosion (Moorhead, Ference, Neck 1991). The Challenger

disaster stands as a case study and testament to how disruptive groupthink effects can be when a

group is tasked with a high stakes, difficult decision where unanimity feels imperative and power

is unevenly distributed. Therefore it is easy to see that groupthink could have wreaked ruinous

effects on the economy as it could easily have impaired the decisions of banks, Congress, the

Federal Reserve and other agencies tasked with taking action in the years leading up to and

during the crisis. Just like herding and the availability heuristic, it is apparent groupthink factors

crucially into both common and high pressure decision making and likely played into the

decisions made during the crisis of 2008.

Herding behavior can lead even the most rational decision maker awry under

circumstances of uncertainty, which is exactly what occurred during the housing boom, the

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advent of CDOs, and the panic after the collapse of Lehman Brothers. The housing boom

exemplified all the ways in which herding behavior could lead to ruin. Coming off years of low

interest rates and a seemingly perpetually growing market, nearly everyone was trying to get in

on the action. From 2002 to 2006, real housing prices skyrocketed over 30% (Baker 2008).

Houses were selling like hot cakes and funding it was the burgeoning mortgage market. As in

any national market, there are the experienced investors and then there are the naïve investors.

Certainly there were wealthy agents who knew that while the market was bullish, it was a bubble

and prices were well above fundamental values and would not last. However, there were also

people just finding out about this incredible, booming housing market and trying to get a quick

buck with no concept of fundamental values or technical analysis (Szyszka 2010). These

investors, faced with uncertainty, could only observe the actions of the agents around them

(Shiller 2008). They might see their neighbor buy a house for $500k and flip it for $700k two

years later and think to themselves that they surely want in on the action too. If everyone around

them is making money, then it follows that they can and should get in on it too. Furthermore,

they can only assume the agents around them know better; that they know investing in housing is

a solid idea since they’re evidently profiting. Consider the example from earlier with the urns.

Even if one person has information on the market, if they are even a little uncertain, they can be

swayed by the implicit knowledge demonstrated by the decisions of other agents, resulting in an

information cascade. It follows that a wave of agents could be caught up in the so called

“irrational exuberance” despite displaying somewhat rational herding behavior. From here

spawns a bubble since, to profit, one must only find someone willing to buy for more than they

originally paid. With enough agents and enough “irrational exuberance”, the price just keeps

rising and rising, making the lucky investors rich until it pops and someone’s left holding the

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bag. Surely there were more factors contributing to the speculative bubble than herding behavior,

but it is easy to see how such a phenomenon could aid in bolstering an already exuberant bubble

(Ouarda, Bouri, Bernard 2013). This is especially true given a market where information, such as

the fundamental value of a house, is not obvious or even necessarily possible to determine

accurately.

Piggybacking on the booming housing market, banks and other financial agents began to

buy and sell CDOs backed by subprime mortgage loans in the years leading up to the crisis,

leading to a market failure driven by obfuscation and ultimately herd behavior. Two factors set

the stage for the crash: one being the short-sighted extension of subprime mortgages which

backed CDOs and the other being credit default swaps, supposedly insuring these CDOs.

Investors weren’t alone in their “irrational exuberance,” loan agencies too got carried away,

giving out mortgages to anyone with a pulse under the impression the housing market would just

keep going up. Of course, as soon as one agency started doing this, other agencies followed suit

assuming the others knew better. Due to poor regulations on background checks, the soundness

of these mortgages was uncertain, leading firms to turn to the actions of the agents around them

for information. The same story unfolds as before and suddenly a herd of agencies are all giving

out shoddy mortgages as a result of herd behavior. Problems arose when CDOs began to be

backed by these subprime mortgages and were further exacerbated by the failures of ratings

agencies who simply could not decipher and evaluate the heavily obfuscated CDOs (Szyszka

2010). Furthermore, the advent of credit default swaps led to some individuals mistakenly

lauding CDOs as virtually risk free. Banks essentially found themselves in the same situation as

the investors in the housing bubble. Unable to ascertain the true value of these CDOs, agents

took cues from experts and rating agencies who supposedly knew better and began buying them

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up. Other banks joined in, following the herd and trying to turn a profit off the speculation.

Brunnermeier summarizes the mindset of the banks at the time nicely as “don't focus on the

fundamentals ... focus on the other players” (Berman 2007). Thus the banks fell victim to herd

behavior just like the investors during the housing boom. The end result of the exuberant

speculation mirrored the bust in the housing market; once the music stopped, the firms left

holding the bag found themselves facing insolvency with trillions of dollars sunk into CDOs,

now essentially worthless after the massive wave of mortgage defaults in 2007 (Brunnermeier

2009). While greed and ignorance certainly loom large as factors, herd behavior too heavily

influenced and spawned many of the poor decisions leading to the bust in the subprime mortgage

market.

After the bust, the Federal Reserve unexpectedly chose not to bail out Lehman Brothers,

setting off the final spark plunging the world into a global recession following a massive

contraction propagated by herd behavior. The general expectation in late 2008 was that the

Federal Reserve would bail out Lehman just as they bailed out Bear, Fannie Mae, and Freddie

Mac. However, in a stunning decision (which will be discussed later on) the Fed chose to let

Lehman fail, setting off a massive banking panic. By the end of 2008, the volume of lending had

fallen 47%, dipping below a fourth of the level it had been just 18 months prior (Ivashina,

Scharfstein 2010). Lehman had its hands in many cookie jars and was the largest bankruptcy in

US history at the time, so certainly a good portion of this decline can be explained by their

interconnectedness. The extent of the contraction cannot solely be explained by the fallout from

Lehman though. Rather, what made the contraction so deep was a sense of panic which led to

herding. Obviously many banks did contract lending for the right reason: to recoup their balance

sheets and maintain solvency. Seeing this though, banks uncertain about the stability and

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soundness of the other banks, began to mimic the contraction. If one looks at the situation from

the standpoint of a bank, the decision to herd is fairly rational. Following the collapse of

Lehman, a bank loses confidence not only in the solvency of its fellow banks, but also in the

Feds willingness to rescue an insolvent bank. Loaning to an insolvent bank that ends up

defaulting could be disastrous for a firm already strained by the crisis. With all this uncertainty,

the most easily observable information is the contraction of loans from the other banks,

implicitly signaling knowledge that loaning is a bad decision for the time being. Thus a bank

would be rational to engage in herding behavior and contract lending themselves, which accounts

for a portion of the massive contraction at the end of 2008.

Another factor at play influencing decision making is the availability heuristic, fueling

the housing boom, moral hazard problems, and the banking panic in 2008. As previously

described, one of the major problems during the housing boom was a lack of information. In lieu

of solid reports on fundamental values or market trends, many investors relied heavily on media

and anecdotal reports. Problems arise when the media is responsible for disseminating

investment information. For one, there is always a slant. The media wants a story and will

always try to create one even if it isn’t actually there. It should come as no surprise then that the

media fed into the “irrational exuberance” of the time. In fact, the National Association of

Realtors funded a public-relations campaign to advertise how investing in the housing market

will make everyone rich (Shiller 2008). On top of that, people were actually making money and

it was easily observable. All an individual had to do was look outside and see the “for sale” signs

coming down as quickly as they were put up. The key aspect is the appeal. Seeing everyone

getting rich invokes jealousy and a feeling of being left out. Naturally an agent remembers the

story in the news of a man making millions in the housing market; it appeals to his emotions, his

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ambition. What he doesn’t remember is the boring economist droning on about bubbles or the

house down the road which just got foreclosed on. Thus through the availability heuristic, an

agent would overestimate the probability of profiting off the housing market. This mentality is

evidenced by the oft-cited “irrational exuberance” of the time; people in and outside the world of

economics earnestly believed the market would never go down. Evidently, the availability

heuristic was one of many factors propagating the exuberant nature of the housing bubble

leading up to the crisis of 2008.

The availability heuristic further played into the crisis of 2008 following a string of

bailouts and the proliferation of moral hazard problems. The bust in the subprime mortgage

market led to a massive credit crunch, leaving many banks facing insolvency. Among them were

Bear Stearns, Fannie Mae, and Freddie Mac, all of whom were bailed out by the Fed. It follows

logically that a bank would see the actions of the Fed as a signal of their willingness to save

future banks on the verge of default. In fact, establishing confidence is part of the benefit of a

bailout since confidence leads to lending and prevents a panic. However, confidence is a double

edged sword. A bank confident the Fed will bail them out of trouble, should it come to that,

might feel emboldened to take on more risk and feel less of an obligation to deleverage, which is

exactly what happened with Lehman Brothers. After the bailout “Lehman was among the most

leveraged of the major investment banks; it was unwilling to raise capital; it had a poor

reputation for risk management” (Mishkin 2010). What ensued was the infamously devastating

bankruptcy filing which brought on the worst days of the crisis. The availability heuristic can

help explain Lehman’s reckless behavior. A bailout is a huge deal, something that would be

plastered all over the news and would be on the minds of every financial agent. With the bailouts

embedded in their minds and therefore vivid and memorable, agents unknowingly relying on the

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availability heuristic would consider a bailout likely, perhaps overestimating. Relying on

heuristics is a natural human tendency and it is highly likely Lehman grew more reckless as a

result, as demonstrated by their balance sheet. Furthermore, if Lehman was engaging in reckless

behavior following the bailout, it is not too far of a stretch to assume other banks were as well,

following the same thought process. Therefore the availability heuristic most likely influenced

banks’ decision to take on more risk following the Fed’s bailouts.

After the fall of Lehman Brothers and the resulting deterioration of bank balance sheets, a

banking panic ensued, driven partly by the availability heuristic. As discussed earlier, the fall of

Lehman led to a massive contraction in lending, much of which was necessary, but some of

which stemmed simply from a sense of panic. After the Fed let Lehman fall, there was little

confidence among the banks that they would be saved should they face insolvency. Moreover,

their asset prices were taking a beating with the stock market falling precipitously, declining by

the end of 2008 to a half of its 2007 peak (Mishkin 2010). The crash in the stock market

combined with the collapse of Lehman, combined with the bust in the subprime mortgage market

spelled trouble for bank balance sheets. However banks overreacted, causing a panic. While

some of this overreaction was explained earlier as a result of herd behavior, undoubtedly some of

it was rooted in the availability heuristic. Certainly banks had a real incentive to contract lending,

but it may also be true that banks overestimated the likelihood of going insolvent. Seeing a titan

of the financial district like Lehman go under would leave a lasting impression on the banks. If it

didn’t, the bombardment of headlines and news stories about Lehman and other banks edging on

failure certainly would. With the idea of bank failures so prominent and daunting, it is highly

likely banks succumbed to the availability heuristic in assessing the state of the market. Being

overly pessimistic, a bank would err on the side of caution, cutting loans and liquidating assets,

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leading to a panic. The actions taken by the banks are somewhat understandable though. In a

market essentially in free fall, inundated with overly complex assets and intentional obfuscation,

information is limited. Even if there was information available, banks would be hesitant to put

much faith in it after getting burned in the subprime mortgage market where the experts

blundered and determined CDOs were risk less, secure investments. As such, a decision maker

would need to trust their gut to some extent and “the gut” doesn’t always think rationally. Rather,

the gut follows the hype; whatever captivates and speaks to the emotional side of decision

makers. Evidently, the media and events of the time swayed decision makers to panic. The

contraction and subsequent crisis demonstrate how in high pressure situations, especially with

limited information, the availability heuristic can lead even the most rational agents to ruin.

While herding and heuristics affect the individual, groupthink affects an entire group,

leading to adverse conditions for decision making, as demonstrated by the collapse in the

subprime mortgage market and the Fed’s decisions to rescue Bear Stearns and let Lehman

Brothers fail. A firm on Wall Street creates a perfect storm for groupthink effects. Wall Street is

notorious for their cutthroat firing practices where job security is transient and everything comes

down to results. As such, an individual investor would be strongly motivated to not rock the boat

and dissent from the conventional practices of the firm. Thus there is a strong incentive for

unanimity among the group and a substantial pressure to make the right decisions. Additionally,

above the investors are the executives calling the shots. It stands to reason that, given the

propensity for firing, there was an imbalance of power at play. Furthermore, the intentional

obfuscation of CDOs, poor screening in the mortgage market, and the sale of inflated ratings

created a market riddled with uncertainty (White 2010). With the circumstances prime for

groupthink effects, it is understandable that investors made poor decisions with CDOs. As

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mentioned earlier, the prevailing notion of the time was that CDOs were a strong, secure

investment, especially with the housing market booming. Even better, with the advent of credit

default swaps, CDOs were lauded as virtually riskless. Of course, there are no free lunches in

economics; an asset with no risk and high returns should set off alarms for any seasoned

investor. Surely an expert would understand that such an asset is simply too good to be true, that

there must be a catch. Well, many people did. Gillian Tett made waves publicizing the fallacy of

considering CDOs risk free, how such practices would lead to a market collapse and ultimately, a

crisis (Tett 2009). In fact many economists saw the collapse coming as a result of the housing

bubble bursting, including Zandi, Shiller, Gramlich, Ranieri, and Bordo to name a few (Bianco

2008). With all of these warnings, one must think that the investors on Wall Street, whose job is

to stay informed on the markets, would have at least some notion that perhaps the market was

taking on too much risk and heading for disaster. If such circumstances occurred, they are not

demonstrated by actions, however it’s no stretch to infer warning signs were seen and dismissed.

It’s worth noting too that a Wall Street agent vocalizing their misgivings presents serious issues

economically and potentially legally should the media get wind of it. The result is a strong

incentive for agents to fall in line, keep quiet, and push onward with the group as if everything is

fine. Under such incentives in such an environment, groupthink most likely factored into the

decisions leading to the collapse of the subprime mortgage market.

In the fallout of the bust in the subprime mortgage market, the Fed chose to rescue Bear

Stearns, ignoring potential moral hazard issues that would arise, stemming from groupthink. The

Fed is comprised of a board of governors with a president overseeing and directing their

operations. They face the monumental task of ensuring the soundness of the American economy.

Not only that but if anything goes wrong, it’s the Fed and especially the president taking the

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blame, being lambasted in every headline across the country. With so many people coming for

their head, the job can be seen as more than a bit stressful. One blunder could lead to not just

economic ruin, but the death of a reputation and enough vitriol to wither even the thickest of

skins. Clearly there is a monumental pressure to make correct decisions. One challenge is the

inherent uncertainty of macroeconomics. Even with the best information, the best research, there

will never be full information in a system as complex and chaotic as a national economy. Even a

market as well researched as the stock market still defies prediction and full comprehension.

Hence the uncertainty. Additionally, with the eyes of the world watching, no member wants to

step out of line since dissension means a target on their back and breeds uncertainty, which

engenders a lack of confidence, which in turn can be ruinous for the economy. Thus there is

pressure for unanimity. Beyond that, there is a president on top with essentially absolute

authority and thus there arises an imbalance of power. With a situation ripe for groupthink

effects, it should be expected the Fed may arrive at a less than perfect decision. In the case of

Bear Stearns, there were serious concerns that bailing them out would lead to moral hazard

effects, encouraging banks to take on more risk down the line. Lehman Brothers’ substantiated

these concerns when they failed a few months later. The Fed was warned there would be moral

hazard effects; Secretary of the Treasury Henry Paulson warned Bernanke and adamantly pushed

to prevent the bailout, but was ignored (Kirk 2009). Regardless though, moral hazard is a well-

known issue in economics; it doesn’t take the Secretary of the Treasury to point it out and surely

a brilliant economist such as Bernanke, as well as the rest of the Fed, understood the

ramifications of the bailout. Yet they went ahead with the bailout under the justification that Bear

was too interconnected to be allowed to fail, that such an institution going under would tank the

economy. Whether or not the Fed blundered is not the point of this paper though, what is

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important to note though, is the circumstances and the situation likely led to groupthink effects

which hampered the Fed’s decision making in deciding on the Bear Stearns bailout.

The Fed’s move to bailout Bear led the market to believe they would bailout other banks,

but instead the Fed chose to let Lehman fail in a highly questionable decision, potentially

brought about by groupthink effects. It seemed clear the Fed was demonstrating a willingness to

save struggling financial institutions following the rescue of Bear, Fannie Mae, and Freddie Mac.

After all, the point of a bailout is to relieve unease and send a vote of confidence to the market,

preventing a panic and run. The Fed even expressed in their justification for Bear’s bailout, a

concern with letting a large, connected firm fail. With this in mind, one can only imagine the

shock when Lehman, a major player in the financial sector, declared bankruptcy. Looking back

on the situation, there was definitely an atmosphere conducive for groupthink as before with

Bear, except now the uncertainty was worse. Determining the solvency of bank is incredibly

difficult, especially when the value of assets are incredibly volatile or difficult to determine. The

problem becomes even more difficult with Lehman purposely misrepresenting and obscuring

their balance sheets (Valukas 2010). Furthermore, after the political backlash following the

bailouts, the Fed surely felt more pressured than ever. In the end, the Fed decided to let Lehman

fail, citing Lehman as not being too interconnected to do too much damage to the economy as

well as a desire to prevent moral hazard going forward. As it turned out though, Lehman was

connected enough to bring the economy to its knees, which couldn’t have been a surprise. The

Fed was warned that it would happen; Jean-Claude Trichet, then president of the European

Central Bank, was in close talks with Bernanke and Paulson and warned them that Lehman

failing would spell a global financial crisis (Trichet 2014). Even more, Christine Lagarde, then

prime minister of France, also warned Paulson a crisis would result from Lehman’s collapse

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(Gabe 2015). Given all of these warnings, the Fed still chose to let Lehman fall, contradicting

their own reasoning from before, and giving rise to the greatest financial decline since the Great

Depression. The Fed’s questionable decision can undoubtedly be tied to the caustic atmosphere

of the time, allowing for groupthink to impede their judgment.

The story of the crisis of 2008 is an intricate one, wound up in red flags and questionable

decisions, but also fraught with lessons. The sequence of events and the mechanisms which

served to propagate them, bringing about the severe economic of downturn of 2008, demonstrate

how herd behavior, heuristics, and groupthink can lead even the most rational agents astray given

adverse circumstances and incentives. Looking back, many of the events and blunders leading up

to the crisis were discernable and more importantly, preventable. Moving forward, policy must

stress an emphasis on full disclosure and allocation of information, regulation and oversight in

the financial sector, and management of incentive systems. In increasing regulation, efficiency is

sacrificed, but if the crisis has demonstrated anything, it’s that often times a free market is less

efficient and even ruinous when there are adverse incentives and biases at play. Inevitably,

people will follow human nature and in doing so, fall back on their most basic cognitive and

behavioral shortcuts, but that should not be discouraging. Instead, these phenomena should guide

the framework of policy making, driving the philosophy and ambitions of regulation. Fighting

human nature is like swimming upstream; it might work for a time, but eventually the current is

going to win out. In the end, it’s best to plan around the current, which is exactly the direction

policy must take in order to prevent future crises.

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References

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Bianco, Katalina M. The subprime lending crisis: Causes and effects of the mortgage meltdown. CCH, Wolters Kluwer Law & Business, 2008.

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