03/25/2013 03:47 pm ET

Many Of Wall Street's Toxic Mortgage Security Cooks Ate Own Cooking: Study

Maybe Wall Street fleeced itself.

A new study suggests that, rather than just leading innocent investors to take losses by betting on a housing market they knew would crash, many bankers who cooked up toxic mortgage securities before 2008 were eating their own cooking. They bought second houses and traded up to pricier homes right up until the crash, and then they sold those houses at steep discounts after the bust. (h/t Justin Lahart of the Wall Street Journal.)

These findings cut close to the heart of the argument over what policy makers should do to prevent another crisis. One school of thought has it that Wall Street acted as it did out of pure greed, pushing investors to take big risks that Wall Street knew would go wrong, only to make some extra cash and get a bigger bonus. Give Wall Street different incentives and you can prevent the next crisis, according to this school of thought.

And this school is not entirely wrong!

But this study hints at why simply changing banker incentives is not enough to prevent another crisis: Wall Street's own congenital optimism -- the inability, or refusal, of bankers to stop and think about how things could go horribly wrong -- will almost certainly contribute to the next crisis, no matter how we change banker pay schemes.

The study, by economists at the University of Michigan and Princeton, tracked the home-buying behavior of a group of people in the mortgage-securitization industry, those involved in bundling mortgages into often-toxic bonds. This was the beating heart of the financial crisis, and we have already seen how many actors in this market knew full well that they were selling garbage. In emails to each other they described the investments as a "shitty deal," a "sack of shit," or the weirdly creative "shit-breather."

There were a lot of people fleecing investors in the run-up to the crisis, people who sold garbage knowing full well it was garbage. We do need to change incentives so that these people might be less tempted to act that way in the future. Sending some of them to jail might also help, though that's never going to happen.

But apparently not everybody involved in this market was so cynical. The study compared their home-buying behavior to those of two groups of people who were not involved in the mortgage market at all: non-real-estate lawyers and Wall Street stock analysts. According to the study, the Wall Streeters involved in bundling mortgages were more likely to make dumber home-buying decisions before the crash.

And mortgage-bundlers living in bubblier parts of the country were more likely than their peers to spend wildly on housing before the crash, as were bankers working for the riskiest investment banks, including Bear Stearns and Lehman Brothers, the study found.

The implication is that the people in the market for mortgage-backed securities, after spending months trying to convince investors that home prices were never going to crash, managed to convince themselves of the same thing. And the crazier and more aggressive their housing markets and banks got, the more optimistic some of these bankers got.

This is actually a common theme on Wall Street, where optimism is almost always preferred to pessimism. In a way, this preference makes sense: Optimists take the big risks and thus succeed in financial markets.

But this natural optimism often morphs into what the study's researchers call "group think, cognitive dissonance,
or other sources of over-optimism." And that's when things get dangerous, for Wall Street and the economy as a whole. Those Cassandras who warn of what could go wrong are often ostracized and risk losing their jobs. Meanwhile, Pollyannas not only get to keep their jobs, but are usually offered better jobs, no matter how often their rosy forecasts are proven wrong.

Changing this over-optimistic mentality could help prevent the next crisis. But it's going to be even harder to do than changing incentives or sending people to jail, and that's really saying something.



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