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FARAH STOCKMAN

The hazards of optimism

Dated, overly positive risk models helped fuel the financial crisis

A home in San Antonio in 2009.

Eric Gay/Associated Press file

A home in San Antonio in 2009.

A few months ago, a friend of mine who made a fortune in hedge funds sent me something he wrote entitled, “What went wrong and how to fix it.’’ It was about the economy — 4,880 words — full of terms my brain could hardly wrap itself around.

“Andy,” I asked him. “I’m not sure I can understand this. Can you translate into English?”

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“Look,” he told me. “There’s a whole group of people out there who blame the economic collapse of 2008 on Barney Frank. All sorts of right-wing pundits blame Barney for pushing for community loans. There is this narrative out there that says subprime lending was the cause of everything, the whole financial crisis. But it isn’t true.”

According to Andy, the financial Armageddon of 2008 was caused by something else entirely. Something even stranger and more unforgivable than Barney Frank. Something that we never thought could do us so much harm: Universal, unwarranted, unwavering optimism.

Sure, housing played a role. It’s never healthy when people buy houses under the assumption that prices will always go up. But it wasn’t just housing that experienced a bubble. The cost of high-yield bonds and securitized portfolios soared, as if there was no way you could ever lose on them. The sovereign debt of nations shot through the roof, as though there was no chance that a country would ever default.

This unrealistic optimism — this “chronic undervaluing of risk,” as Andy called it — fueled bubbles in every nook and cranny of the economy. And the reason was simple: For the previous two decades — from 1983 to 2006 — we experienced a golden age of stability. Recessions were infrequent and mild. The United States and Europe had low inflation and steady growth. We simply forgot that real turmoil was possible.

It even goes beyond human memory. “The risk models of banks and investment firms are data-driven,” Andy said. The data they threw into their models came from the last 20 years, a period of unusual calm, when property prices rose steadily. They put the numbers in the machine to calculate risk, and concluded that the probability of disaster was incredibly low.

“The people making those models did not realize how primitive their models really were,” Andy said. “The research reports coming out of the banks seemed to assume that Alan Greenspan had found a secret sauce that eliminated the business cycle.”

Those overly optimistic risk models were used to determine the price of everything from bonds to real estate to insurance.

But in Latin America, Japan, and Russia, people didn’t get nearly as optimistic as they did in Europe or the United States. Latin America remembered the Peso Crisis of 1994. Japan remembered its “lost decade” in the 1990s. Russia remembered its own debt crisis in 1998. They had no such illusions about gambling on something that couldn’t lose. The data in their models correctly showed the world for what it was: a volatile place steeped in the possibility of failure. Their economies did not suffer as much in 2008.

So had extreme optimism really caused the crash? Manju Puri, a professor at Duke University, couldn’t answer that question. But her research confirms that too much optimism can indeed be a hazard.

In 2006, she studied the financial choices of “extreme optimists” and found they make far more reckless decisions than people who are only “moderately optimistic.”

“Extreme optimists work fewer hours, save less money, and are less likely to pay off their credit cards immediately,” she said. When they do invest, they tend to bet heavily on a few stocks, rather than spreading their risk among many.

So what’s the solution? Should we teach the value of pessimism in school? Should we stockpile toilet paper like Grandma in anticipation of the next Great Depression? Convert our 401(k)s into gold coins?

“Not exactly,” Andy said.

It’s not that we need to become pessimists, he said, but rather we need a better understanding of risk. And we need companies and individuals to make better choices about managing risk, so that they can withstand a crash in the future.

“Great, “ I said. “How do we do that?”

Andy replied with another 4,000 words, which my brain could hardly wrap itself around, and which have yet to be translated into English.

Farah Stockman can be reached at
fstockman@globe.com
. Follow her on Twitter @fstockman.
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