Sunday, September 02, 2007

Incentive Cause Bias: Munger Writ Large

I have been “riffing” lately on the ideas of Charlie Munger (please check the Charlie Munger category on the blog) and a recent speech by Ben Bernanke, chairman of the Federal Reserve, caused me to sit up and take notice. One of Munger’s categories of “human misjudgement” is the “incentive-cause bias” or, the tendency of, as Munger explains, salt salesman to tell you how much salt you need, or hammer-owners to see every problem in nail-like terms. Here is Bernanke, describing one of the key causes of the mortgage meltdown (italics mine):

The traditional model of mortgage markets, based on portfolio lending, solved
these problems in a straightforward way: Because banks and thrifts kept the
loans they made on their own books, they had strong incentives to underwrite
carefully and to invest in gathering information about borrowers and
communities. In contrast, when most loans are securitized and originators have
little financial or reputational capital at risk, the danger exists that
the originators of loans will be less diligent. In securitization markets,
therefore, monitoring the originators and ensuring that they have incentives to
make good loans is critical. I have argued elsewhere that, in some cases, the
failure of investors to provide adequate oversight of originators and to ensure
that originators' incentives were properly aligned was a major cause of the
problems that we see today in the subprime mortgage market
(Bernanke, 2007). In recent months we have seen a reassessment of the problems of maintaining
adequate monitoring and incentives in the lending process, with investors
insisting on tighter underwriting standards and some large lenders pulling back
from the use of brokers and other agents.

In other words, there was no incentive for the underwiters to scrutinize the credit risks of the borrowers, and plenty of incentive to turn those mortgages around and get them out the door.

The incentive-cause bias is alive and well and has come close to toppling the banking system. Score another one for Charlie Munger.


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