/* Google Analytics Code asynchronous */

Tuesday, October 7, 2008

It's all in your head

COGNITIVE ERRORS

AS calls attention to Megan McArdle's piece on the foundation of ... quasi-rational economics, to borrow a phrase, as it relates judgment errors that contributed to the current 'financial panic'. I like reading Megan.

Can the astute reader spot why MM's piece might be the subject of ... cognitive error itself?

Without knowing the full dimensions of all of what is going on, I would hesitate to guess about the causes, let alone the errors (unless it was a really, really wide guess), apart from those things that are obvious contributors.

For instance, I have yet to see solid statistics on the evolution of the subprime and alt-a market. Some datasets suggest that there was a great deal of fraud going on and I'd like to be able to account for that, as much as buyers being too optimistic about home prices.

I wouldn't presume to generalize about what people knew or were thinking about 50 years of home price rises.

FICO SCORE MADNESS

On the other hand, it's fairly clear that lenders were just plain over-confident in something as flimsy as a FICO score, which was 'invented' to provide a low-cost *guess* about someone's financial capacity and willingness. Too many people bet their companies on that. I'd rate that as just stupid, not as a cognitive judgment error.


What's worse, so many are still treating this ridiculous measure as if it meant something (e.g. Suze Orman) or was a usable figure. FICO is a "black box". It is impossible to tell how any one of your actions will affect your FICO score, except at the extremes... Trying to "manage" your FICO score is like trying to catch a fish with your hands!

As for writing CDS on mortgage-backed securities... Well, no one has pockets deep enough for that, to sell a hedge of the business-cycle / credit-cycle. I'm not sure yet, whether this falls into the realm of cognitive error, because the whole story isn't out in the public yet. For instance, it's not clear how well hedged these CDS are or can be. For now, it looks more like an agency problem: the people under-writing the risks and collecting at payday were not the ones who were responsible for saying ... "enough, the cup is full".