Tag Archives for " madness of crowds "

What Really Caused the Recession?

I've seen a lot of stories about what caused the Mortgage Meltdown, the Credit Crunch, and the recession (some are even calling it a depression). On the drive in today, the REAL answer finally came to me.

As in all complex things in life, there wasn't one specific cause. Here's my general thought process on this topic.

People who want to get to the root of any cause always use a root cause analysis to determine the true cause of any issue. One of the practices that process improvement folks use is the fishbone diagram, where if you keep asking "why?" to a question you'll get to the root of it.

But this simple approach often neglects the contributing factors to an issue or a failure. For example, a barn might have caught fire and burned to the ground. The root cause might have been determined to have been a spark from a passing-by freight train.

But the contributing factors were that there was damp hay in the barn, along with kerosene, dry timber, a poorly-maintained exterior, and weeds that had grown rampant over the course of several years.

All of these things led to the fire. Of course, the fire could not have started if not for the spark. But the weeds, hay, timber, etc. allowed the fire to spread at such a rate that the fire crew could not stop it before the entire barn burned down.

Such is the case with the economy. There were many contributing factors: Declining home values, rising bad debt, companies trying to stay afloat cutting staff, phoney financial instruments dreamed up by mathematicians rather than business folks, etc. The list is literally endless.

But what was the root of it all?

As in any mania, it was the madness of crowds. Adam Smith's "invisible hand" and "pursuit of self interest" was the downfall.

Home buyers thought, "If I don't buy this house now, somebody else will."

"Or, if I don't buy this house today, it will cost me $60,000 more to buy this house in 6 months." (By the way, this was the rate of price appreciation for a below-median home price in the Bay Area in California in 2003-2006.)

Lenders said, "If I don't fund this mortgage, somebody else will."

Insurers surmised, "If I don't insure this asset, somebody else will."

Bottom line:

If I don't _____ this, somebody else will!

It was all about getting "it" before somebody else got "it." Or, in other words, what I call "relative greed." It wasn't that everybody was greedy, in and of itself. It was more along these lines:

Scenario 1
You get a 10 percent pay raise. Your neighbor gets a 15 percent pay raise.

Scenario 2
You get a 5 percent pay raise. Your neighbor gets nada.

Do you know which one most people would take? Yeah, #2. It's getting "more" than your neighbor, co-worker, competitor. That's what happened here, in my humble opinion.

It's also "the market" filling in voids. If Bank of America doesn't do this mortgage, Wachovia will. And Wachovia did. And did, and did and did and did.

BofA saw this and said, "We're losing market cap. And we're the biggest and baddest bank around." So, they got into the game, and then some!

People did it, too. If I don't buy a house now, I may never be able to afford one.

"Investors" did it, too. If I don't buy this duplex now and flip it, I may never get another golden opportunity like this.

Do yourself a favor: Read Extraordinary Popular Delusions and the Madness of Crowds.

You only really need to read any one of the stories. They're all the same, really. Market goes up and up, creating self-fulfilling prophecy. Something happens. Market goes down and down, creating self-fulfilling prophecy. What stops it? Who knows?

Money isn't everything. It's the only thing. Wait. That's only for football.

Enjoy life. Spend time with your family.