Distorted beliefs and the financial sector

Ing-Haw Cheng, Sahil Raina, Wei Xiong, 11 April 2013



What led Wall Street to take excessive risks in the housing market before the 2008 financial crisis? A leading contender is that Wall Street took excessive risks because of incentives that were not appropriately aligned with outside stakeholders.1 Several papers written since the 2008 crisis have documented significant evidence that the practice of securitising mortgages in the originate-to-distribute model contributed towards lax screening of subprime borrowers.2 This view has influenced a substantial amount of policymaking, where there is ongoing discussion of having lenders keep more ‘skin in the game’ and of reforming executive-compensation structures.

But there is another possibility: distorted beliefs may have been at play. An environment where households neglect risk and yet demand safe assets may have endogenously fostered the very financial innovation of perceived risk-free assets that enabled house prices to rise with credit expansion, subsequently sparking the crisis (Gennaioli, Shleifer and Vishny 2011; 2012). Once prices started rising, wishful thinking may have led to contagious over-optimism, collective wilful blindness, and groupthink among agents in the financial sector (Benabou 2011), an effect which may be exacerbated by cognitive dissonance (Barberis 2012). Indeed, during the prime years of the housing boom, the literature surveying the housing market had emphasised and debated the possibility of distorted beliefs influencing house prices (Himmelberg, Mayer, and Sinai 2005; Mayer 2006; Shiller 2006, 2007; Smith and Smith 2006).3

New evidence from personal home transactions

Our recent study (Cheng, Raina and Xiong 2013) provides evidence suggesting that mid-level managers in the mortgage-securitisation business were largely unaware that lax lending standards in the subprime-borrower market would lead to a widespread crash in the wider housing market.

  • Many of the 400 managers in our sample – mid-level vice presidents and managing directors working both on the buy and sell sides, whom we collectively refer to as ‘securitisation agents’ – are in organisational roles whose responsibilities would have included understanding the pricing of securitised mortgage instruments.
  • We examined their personal home transactions and found that they neither managed to time the market nor exhibit any cautiousness by staying out of the housing market.

In contrast, they increased, rather than decreased, their housing exposure during the boom period through second-home purchases and swaps into more expensive homes, relative to a control group of S&P 500 equity analysts (not covering homebuilders) and non-real estate lawyers. This is shown in Figure 1, which plots the number of these types of purchases per homeowner through time. The equity analysts and non-real estate lawyers are employees in the financial industry and wealthy members of the general public, respectively, who arguably should have little private information regarding housing markets.

Figure 1. Buying second home or swapping up (normalised by adjusted homeowners)

Notes: This figure plots the intensity of second-home purchases and swap-ups for securitisation agents, non-homebuilder S&P 500 equity analysts, and non-real estate lawyers. The intensity is defined as the number of such transactions divided by the number of homeowners at the beginning of each year.

Securitisation agents also failed to divest homes before the bust. We benchmark our securitisation agents’ overall home portfolio performance against a buy-and-hold strategy of houses they owned as of the beginning of 2000, assuming that all purchases were fully collateralised, and find that securitisation agents underperformed this benchmark more than their equity analyst counterparts, as shown in Figure 2.

Figure 2. Performance index (cumulative return less cumulative buy-hold return)

Notes: This figure plots the average performance index for each group, defined as the initial-wealth-weighted average difference between the cumulative return on observed self-financed trading strategies and the buy-and-hold return of the initial stock of houses, where 2000q1 is taken as the initial quarter.

These effects are more pronounced in certain groups of agents. Buying second homes during the peak boom years was more common among agents living in the relatively bubblier southern California region compared to the New York metro region, even after controlling for fixed differences between these two markets using our control groups. Securitisation agents working on the sell-side and for firms which had poor stock-price performance through the crisis experienced particularly poor portfolio performance relative to those on the buy-side and those whose firms had better stock-price performance, respectively.

Our approach is premised on the idea that personal home transactions reveal beliefs about the path of house prices. However, a home purchase provides a consumption stream that may not be easily found in the rental market. We investigate whether income shocks during the 2004-06 period may have induced managers to purchase homes out of a consumption motive despite knowing a price crash was coming. If securitisation managers expected their income shocks to be transitory but uninformed equity analysts did not, the value-to-income ratios of their purchases should have fallen during this period, where current income is in the denominator. Instead, we find that the average value-to-income ratio of their purchases made in 2004-2006 increased, rather than decreased, slightly over the 2000-2003 average, where current income measured from mortgage applications is in the denominator. This increase was on par with that of equity analysts. We also find that, during the 2007-2008 bust years, sales of properties purchased during the 2004-2006 period were higher for securitisation managers than equity analysts, as job-losers among securitisation managers during this period were much more likely to sell a home than job-losers among equity analysts. These pieces of evidence suggest that our securitisation managers based their decisions on overoptimistic projections of permanent income relative to equity analysts.

Implications for policy and discourse

  • Our evidence does not contradict the existing evidence that bad incentives caused lenders and Wall Street to relax lending standards in the subprime-borrower market.

Our securitisation agents are not subprime borrowers themselves.

  • Our evidence is a first step in an expanded view of the crisis that incorporates a role for both incentives and beliefs.

In particular, if Wall Street was complicit in relaxing lending standards in the subprime-borrower market, our evidence suggests they did so without expecting it to lead to a wider crash in housing markets.

This suggests a need to clarify the discourse both in the public and in policy, which often conflates weakened incentives to screen subprime borrowers with the idea that Wall Street was fully aware that there was an impending across-the-board crisis yet took no corrective action owing to a ‘heads I win, tails you lose’ system.

  • Our evidence further suggests that certain groups of agents may have been particularly subject to potential sources of belief distortions, such as job environments that foster groupthink, cognitive dissonance, or other sources of over-optimism.

Agents living in bubblier areas may have been particularly influenced by stronger sentiment in those regions, while those working on the sell side and firms with particularly high price exposure to subprime mortgages may have been influenced by factors such as groupthink and cognitive dissonance. Such firms may even prefer agents prone to over-optimism due to the lower cost of incentivising them.

Channels for future booms and busts

The presence of biased beliefs complicates policy analysis and reform as it raises alternative channels other than incentives through which future booms and busts may develop. Biased beliefs may also interact with and reinforce effects from poorly designed incentives, which may blunt the impact of any incentive-targeted reforms which do not concurrently address sources of distorted beliefs.

In the context of the housing boom and bust, any weakened incentives to screen subprime borrowers would have been exacerbated if lenders were buoyed by expectations that prices in overall house markets would never fall. The interaction may run in the other direction as well: poorly designed incentive contracts can distort judgement and beliefs, as shown in the novel field experiment conducted by Cole, Kanz and Klapper (2012).
Future booms and busts may arise in other markets:

  • Regulators and academics should devote further attention towards identifying potential sources of groupthink and distorted beliefs in the financial sector, as well as organisational designs that are robust to these distortions.

Absent these initiatives, reforms targeted at remedying incentive problems, such as increased restricted stock holdings for executives or more shareholder say on pay, may be insufficient to prevent the next financial-market crisis, as agents may make poor choices due to biased beliefs even with appropriately designed incentives.


Acharya, Viral, Thomas Cooley, Matt Richardson and Ingo Walter (2010), “Manufacturing tail risk: A perspective on the financial crisis of 2007-09”, Foundations and Trends in Finance 4, 247-325.

Agarwal, Sumit and Itzhak Ben-David (2012), “Did loan officers’ incentives lead to lax lending standards”, Working paper, Ohio State University.

Barberis, Nicholas (2012), “Psychology and the financial crisis of 2007-2008”, in M Haliassos (ed.) Financial Innovation and Crisis, MIT Press.

Bebchuk, Lucian, Alma Cohen and Holger Spamann (2010), “The wages of failure: Executive compensation at Bear Stearns and Lehman 2000-2008”, Yale Journal on Regulation 27, 257-282.

Benabou, Roland (2011), “Groupthink: Collective delusions in organizations and markets”, Review of Economic Studies, forthcoming.

Berndt, Antje and Anurag Gupta (2009), “Moral hazard and adverse selection in the originate-to-distribute model of bank credit”, Journal of Monetary Economics 56, 725-743.

Bhagat, Sanjai and Brian J Bolton (2011), “Bank executive compensation and capital requirements reform”, SSRN working paper no. 1781318.

Bolton, Patrick, Hamid Mehran, and Joel Shapiro (2011), “Executive compensation and risk taking”, working paper, Columbia University.

Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2011), “Understanding booms and busts in housing markets”, NBER working paper no. 16734.

Cheng, Ing-Haw, Sahil Raina and Wei Xiong (2013), “Wall Street and the Housing Bubble”, University of Michigan Working Paper.

Chinco, Alex and Christopher Mayer (2012), “Distant Speculators and Asset Bubbles in the Housing Market”, Columbia University Working Paper.

Cole, Shawn, Martin Kanz and Leora Klapper (2012), “Incentivizing calculated risk-taking: evidence from an experiment with commercial bank loan officers”, working paper, Harvard University.

Demyanyk, Yuliya and Otto Van Hemert (2011), “Understanding the subprime mortgage crisis”, Review of Financial Studies 24, 1848-1880.

Edmans, Alex and Qi Liu (2011), “Inside Debt”, Review of Finance 15, 75-102.

Fahlenbrach, Rudiger and Rene Stulz (2011), “Bank CEO incentives and the credit crisis”, Journal of Financial Economics 99, 11-26.

Gennaioli, Nicola, Andrei Shleifer and Robert Vishny (2011), “Neglected risks, financial innovation, and financial fragility”, Journal of Financial Economics, forthcoming.

Gennaioli, Nicola, Andrei Shleifer and Robert Vishny (2012), “A model of shadow banking”, working paper, Harvard University.

Himmelberg, Charles, Christopher Mayer and Todd Sinai (2005), “Assessing high house prices: bubbles, fundamentals, and misperceptions”, Journal of Economic Perspectives 19, 67-92.

Jiang, Wei, Ashlyn Nelson and Edward Vytlacil (2011), “Liar’s loan? Effects of origination channel and information falsification on mortgage delinquency”, Working paper, Columbia University.

Keys, Benjamin, Tanmoy Mukherjee, Amit Seru and Vikrant Vig (2009), “Financial regulation and securitization: evidence from subprime loans”, Journal of Monetary Economics 56, 700-720.

Keys, Benjamin, Tanmoy Mukherjee, Amit Seru and Vikrant Vig (2010), “Did securitization lead to lax screening? Evidence from subprime loans”, Quarterly Journal of Economics 125, 307-362.

Keys, Benjamin, Amit Seru and Vikrant Vig (2012), “Lender screening and the role of securitization: evidence from prime and subprime mortgage markets”, Review of Financial Studies 25, 2071-2108.

Mayer, Christopher (2006), “Commentary: Bubble, bubble, where’s the housing bubble?”, Brookings Papers on Economic Activity 2006:1, 51-59.

Mian, Atif and Amir Sufi (2009), “The consequences of mortgage credit expansion: Evidence from the US mortgage default crisis”, Quarterly Journal of Economics 124, 1449-1496.

Piskorski, Tomasz, Amit Seru and James Witkin (2013), “Asset quality misrepresentation by financial intermediaries: evidence from the RMBS market”, Working paper, Columbia University.

Purnanandam, Amiyatosh (2011), “Originate-to-distribute model and the subprime mortgage crisis”, Review of Financial Studies 24, 1881-1915.

Rajan, Raghu (2006), “Has finance made the world riskier?”, European Financial Management 12, 499-533.

Rajan, Raghu (2010), Fault Lines, Princeton University Press.

Rajan, Uday, Amit Seru and Vikrant Vig (2012), “The failure of models that predict failure: distance, incentives, and defaults”, Journal of Financial Economics, forthcoming.

Shiller, Robert (2006), “Commentary: Bubble, bubble, where’s the housing bubble?”, Brookings Papers on Economic Activity 2006:1, 59-67.

Shiller, Robert (2007), “Understanding recent trends in house prices and homeownership”, Proceedings of the Federal Reserve Bank of Kansas City, 89-123.

Smith, Margaret and Gary Smith (2006), “Bubble, bubble, where’s the housing bubble?”, Brookings Papers on Economic Activity 1, 1-50.

Soo, Cindy (2013), “Quantifying animal spirits: news media and sentiment in the housing market”, working paper, University of Pennsylvania.

1 The stakeholders include shareholders (Bebchuk, Cohen, and Spamann, 2010; Bhagat and Bolton, 2011; Fahlenbrach and Stulz, 2011) and other stakeholders such as creditors, taxpayers, and society at large (Acharya, et al. 2010; Bolton, Mehran and Shapiro, 2011; Edmans and Liu, 2011; Rajan, 2006, 2010).

2 See, for example, Agarwal and Ben-David (2012), Berndt and Gupta (2009), Demyanyk and Van Hemert (2011), Jiang, Nelson and Vytlacil (2011), Keys et al. (2009, 2010, 2012), Mian and Sufi (2009), Piskorski, Seru and Witkin (2013), Purnanandam (2011), and Rajan, Seru and Vig (2012).

3 Since the crisis, the discussion assessing the causes of the boom and bust in house prices has shifted towards the role of poorly designed incentives, with the exception of a few studies (Burnside, Eichenbaum, and Rebelo, 2011; Chinco and Mayer, 2012; Soo, 2013).

Topics: International finance
Tags: cognitive dissonance, housing, Subprime

Assistant Professor at Ross School of Business, University of Michigan

PhD student at Ross School of Business, University of Michigan

Wei Xiong

Professor of Economics, Department of Economics, Princeton University

Most Read