5 inescapable truths about financial disasters

Striking differences in man-made vs. natural catastrophes

By Inman News Feed
Add Comment Add Comment | Comments: 0 | Posted May. 24, 2010

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Striking differences in man-made vs. natural catastrophes

Jack Guttentag
Inman News

"Since financial disasters are entirely man-made, in principle they should be easier for governments to deal with than natural disasters, which cannot be controlled. Do you agree?"

I don't. Financial disasters are less predictable than natural disasters.

Those who expose the financial system to major risks can often shift their own risks to others; the depth and breadth of a financial disaster can be expanded by contagion; and it may be impossible to protect innocents from becoming victims of a financial disaster without helping the malefactors who caused the problem.

Predictability: The ability to minimize the damage stemming from a disaster depends in good part on our ability to predict its occurrence early enough to react in ways that reduce the damage. While the predictability of many natural disasters (such as the recent earthquake in Haiti) is low, in some cases it is fairly high and rising as the science improves.

For example, in the Mt. St. Helens eruption in May 1980, seismic activity forewarning an eruption occurred some two months earlier, and government-imposed restrictions on access to the danger area based on these early indications limited the loss of life.

Meaningful predictability of financial disasters, on the other hand, is nil. While there are always astute individuals who foresee that trouble is brewing, their knowledge is not translated into government actions to mitigate the damage. A major reason is that counter-opinions may be as widespread and as influential. The counter-opinions, furthermore, are supported by many who are profiting from the activities that are leading to disaster, and who are likely to belong to organized trade groups.

Underlying financial disasters, in other words, are malefactors who profit from the activities that lead to disaster, obstruct any efforts to restrict these activities, and attempt to shift the cost of the disaster to others. There is no counterpart in natural disasters.

Perceptual bias: Human beings in general have a tendency to disregard or undervalue low-probability events that would have severe adverse consequences. This bias probably is protective on balance, because if we focused on every low-probability hazard that might befall us during the day, we would never get out of bed. Nonetheless, the bias plays an important role in both natural and financial disasters.

Consider homebuyers deciding whether to move onto an attractive flood plain that over a long period has averaged a devastating flood every 50 years. The probability that a flood will occur in any one year is thus about 2 percent. Based on experience over many such situations, we know that after some years pass without a flood, people will begin to move in.

The longer the period without a flood, the more people behave as if the likelihood of one has gone down, though there is no rational basis for this belief. This behavior is reinforced by positive contagion: the fact that some have done it successfully encourages others to follow.

The perceptual bias in the buildup to a financial disaster is even more powerful. Consider mortgage lenders who can make a lot of money writing loans for subprime borrowers so long as home prices continue to rise at a rate that is twice the long-term average.

The longer the high rate of appreciation continues, the more lenders jump in the game, as if the longer period increases the likelihood that the price bubble will go on indefinitely. Yet the reality is that the longer the above-normal rate of price appreciation continues, the closer is the date when the bubble must burst.

Positive contagion plays a role here, too: That bank is making a lot of money in this market ... why not us?

The perceptual bias of lenders confronting the subprime market is stronger than that of home purchasers confronting a flood plain in the following sense. If it were known with certainty that there would be a devastating flood in, say, five years, few homebuyers would buy in.

However, if it were known with certainty that the house-price bubble would not pop for five years, lenders would not be deterred at all. They would assume that they could make much more money in the five years than they would lose in the sixth, especially if they can shift most of the loss onto others.

Risk-shifting: Ignoring the potential losses from a future disaster is rational to the degree that such losses can be shifted onto others. Some risk-shifting goes on in the case of natural disasters in the form of subsidized insurance to those exposed to natural hazards, or free assistance rendered after the disaster hits.

But such risk-shifting is small potatoes compared to what can happen in the buildup to a financial disaster.

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