This blog is an excerpt from my book, The Upside of Risk: Turning Complex Burdens into Strategic Advantages for Financial Institutions.
In 2008 researchers in Japan devised an experiment to test how anonymity impacts rule breaking. They divided participants into four groups to play a coin flipping game in private. Two groups were told to anonymously report their results while the other two were instructed to write their name and student ID on their reporting sheet. Half of the participants were told they’d be rewarded with a coupon book worth about $5 if they won. The others were not incentivized.
The laws of probability dictate that there’s a 25 percent chance that participants would get heads or tails two times in a row and win the game. Yet 46 percent of anonymous students claimed they’d won the prize compared to just 21 percent of identified participants. Even the anonymous participants with no prize at stake reported winning at a statistically unlikely rate: 35 percent claimed to have won.
In a surprise to no one who has ever read the comments section of a website, the study results make it clear that anonymity gives many people a green light to engage in antisocial behavior. Why do they do this? There is no accountability for their actions. There is no oversight. There is no risk of being caught.
Risk creates accountability. It makes people and institutions more cautious because they are held responsible for the results.
Failing to account for risk: The story of Washington Mutual’s downfall
There’s no need to create an experiment to test this concept in the banking world. The industry has done a good job demonstrating the point on its own, particularly in the mortgage crisis that helped cause The Great Recession.
Remember Washington Mutual?
In the mid-2000s it was the sixth-largest bank in the country, ultimately reaching $307 billion in assets when it finally failed under the weight of subprime mortgages losses.
WaMu’s downfall was its high-risk lending strategy. As home prices and demand for mortgage-backed securities rose, the bank saw an opportunity in the subprime and alternative mortgage marketplace. Borrowers couldn’t afford the homes they wanted with traditional 30-year fixed-rate mortgages. Higher risk loans, like option adjustable-rate mortgages and cash-out refinances that let customers take out negatively amortizing mortgages, filled a market need for consumers who didn’t always understand how their loans worked.
Meanwhile, because these loans had higher rates, they were worth more than 30-year mortgages when the bank sold them to investors. If a borrower didn’t pay the full amount of the loan, the bank could count the accrued interest as profits. Better yet, from WaMu’s short-sighted perspective, because someone else bought the loans, the risky loans were off the bank’s books. If a loan defaulted, it would be someone else’s problem.
When incentives don’t align with risk and strategy
With risk seemingly off the table, WaMu dove into high-risk lending, pursuing profits. Brokers were rewarded for closing ARMs with much higher commissions than traditional mortgages, motivating many to push the loans on customers, including those who might have been eligible for a fixed-rate loan. The more productive the loan officer, the greater the rewards, including trips to Hawaii as part of the bank’s President’s Club for top performers.
Executives also raked in the cash. The loans increased the bank’s profits, which in turn boosted executive bonuses. Former chairman and CEO Kerry Killinger earned $19 million in 2005 and $24 million in 2006. Shareholders were rewarded with climbing stock prices.
Since WaMu didn’t retain the risk for the loans, it wasn’t concerned about underwriting. Documentation of income was minimal and often nonexistent. In one case reported by The New York Times, a loan officer counted a photo of a borrower in a mariachi costume as documentation of the six-figure income the singer claimed. The bank actively encouraged appraisers to inflate the value of homes so that loans looked more solid and valuable to investors and purchased questionable subprime loans from other originators. It even packaged loans it knew were destined for default and sold them without telling investors about its internal analysis.
Failed oversight: Management knew about this fraud and didn’t care
Management repeatedly ignored reports about fraudulent documents and misrepresentations in mortgages it originated. Those inside the company tasked with managing risk were blatantly ignored.
“WaMu knowingly implemented a High Risk Lending Strategy, but failed to establish a corresponding system for risk management,” concludes a U.S. Senate report on the financial collapse. “Instead, it marginalized risk managers who warned about and attempted to limit the risk associated with the high risk strategy.”
Ignoring risk is not an effective strategy
But ignoring risk is not an effective strategy. When the secondary market for mortgage-backed securities dried up in August 2007, WaMu had nowhere to sell its toxic mortgages and began to take on millions in losses. In the first quarter of 2008, WaMu lost $1.14 billion and half of its stock’s value. That September, facing $180 billion in mortgage losses, regulators seized the bank and sold it to JPMorgan.
It was an ugly ending to a risky strategy, but it wasn’t a unique one. Wachovia faced a similar end, being snapped up by Wells Fargo. Investment banks like Merrill Lynch and Bear Stearns were caught up in the carnage of risky decision making. It all came down to ignoring risk.
Ignoring or not fully understanding risk was a rampant problem which ultimately culminated in the financial crisis.
Related: Creating Reliable Risk Assessments
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