Friday, April 10, 2009

Lenders Blew a Solved Game: When Goals Go Wild

When is the last time you unintentionally lost a game of tic-tac-toe? It probably goes back to when you were around six years old – it’s a solved game. From Alec Wilkinson’s article in the New Yorker, “What Would Jesus Bet?”:

Games for which flawless strategy is known are said to be solved. Tic-Tac-Toe is solved; blackjack is solved; checkers is solved. Chess is not solved, and poker is not, either. Solutions theoretically exist; they are simply too intricate, so far, to be comprehended.

It took 10^14 calculations and 18 years to solve checkers; more on solved games here.

I believe real estate lending was a solved game. Loan to a borrower with good credit and a 20% down payment on a well maintained piece of real estate, and make sure income was sufficient to cover debt service and expenses with at least a 25% cushion. If everyone stuck to those rules, what could go wrong? So, what did go wrong?

I think the short answer is the goal of increased market share caused lenders to go outside the rules of the game. From an article by Drake Bennett on Boston.com (which I found via Wehr in the World):

The argument is not that goal setting doesn't work - it does, just not always in the way we intend. "It can focus attention too much, or on the wrong things; it can lead to crazy behaviors to get people to achieve them," says Adam Galinsky, a professor at Northwestern University's Kellogg School of Management, and coauthor of "Goals Gone Wild," a paper in the current issue of a leading management journal.

Paul Kredosky links to the “Goals Gone Wild” paper, too, and cites this excerpt in his post, “Goals Gone Wild, Ponzis, and the Banks”:

An excessive focus on goals may have prompted the risk-taking behavior that lies at the root of many real-world disasters. The collapse of Continental Illinois Bank provides an example with striking parallels to the collapse of Enron and the financial crisis of 2008. In 1976, Continental’s chairman announced that within five years, the magnitude of the bank’s lending would match that of any other bank. To reach this stretch goal, the bank shifted its strategy from conservative corporate financing toward aggressive pursuit of borrowers. Continental allowed officers to buy loans made by smaller banks that had invested heavily in very risky loans. Continental would have become the seventh-largest U.S. bank if its borrowers had been able to repay their loans; instead, following massive loan defaults, the government had to bail out the bank.

I’ve previously posted on how the quest for market share led Fannie to increase its subprime lending.