(1) Confirmation Heuristic
Confirmation heuristic is a tendency to interpret information in a way that confirms one’s preconceptions, find evidence that supports his/her preference, and discount evidence that does not.
Here, confirmation heuristic caused Wall Street people, bankers, brokers, investors, and even borrowers to make bad decisions due to their overconfidence and inability to see the big picture, contributing to the subprime mortgage crisis.
People naturally tend to seek information that confirms their expectation and hypotheses, even when disconfirming information is more useful. They search for information selectively to enable them to come to conclusion ...view middle of the document...
There were several new kinds of mortgages given out to people who never would have qualified for them before; therefore, the 2% historical foreclosure rate had nothing to do with these new kinds of mortgages. The actual foreclosure rate was expected to go beyond 50%. (Blumberg & Davidson, 2008).
The credit rating agencies failed to make sufficient adjustments from the old data when determining the final value of foreclosure rate and misled the entire industry with AAA ratings.
In my opinion, a more informative figure would be a recent foreclosure rate for the borrowers with similar risks and ability to pay their debts.
Almost everyone in the mortgage industry was guilty of overconfidence. Since they selectively relied on self-serving information such as AAA ratings and the fact that housing prices were rising quickly, they were too certain that housing prices in the US would never go down. Therefore, it was very difficult for them to imagine a disaster or prepare for it.
(2) Social Proof/Pluralistlic Ignorance
We tend to see an action as appropriate when others are doing it. The principle of ocial proof is most influential under two conditions: uncertainty and similarity. (Cialdini, 2009).
No one in the housing market was familiar with high-risk securities such as CDOs because they were new. There were a lot of unknowns and uncertainties among everyone involved.
We are more inclined to follow the lead of people who are just like us. (Cialdini, 2009).
Everyone in the mortgage chain was in similar positions—they were under pressure to create more loans and mortgage-backed securities to feed the global pool of money that had just doubled in size in recent years. Additionally, they wanted to earn large commissions.
Therefore, when some brokers or bankers started to loosened their standards for loans, everyone mindlessly followed suit. Even though Mike Garner’s boss hated the loans, he had to offer them because other people were offering them too. Mike Francis stated, “Something about that transaction felt very wrong way back when. Unfortunately, we did it because everybody else was doing it”. (Blumberg & Davidson, 2008). Unknown to them, everybody was simply reacting to themselves in accordance...