Superstitious learning and the credit crisis


by Kim Pernell-Gallagher

In the aftermath of the credit crisis of 2007-2008, the complex financial instrument known as the collateralized debt obligation (CDO) became both a household name and a dirty word.

In the years leading up to the crisis, America’s largest and most systemically important financial institutions developed heavy exposure to CDOs, often by serving as the underwriters of these financial instruments. When the CDO market collapsed in 2008, many of these institutions were forced to take massive write-downs. The losses banks experienced on their CDO portfolios played a major role in bringing about the credit crisis and the Great Recession.

Why, then, did banks underwrite CDOs, an activity that ended up getting them (and the global economy) into so much trouble?

At first glance, the reasons may seem obvious: banks underwrote CDOs because they are competitive, profit-seeking organizations, and they saw that CDOs offered financial rewards. But explanations like these raise more questions than they answer. How did banks come to determine that CDO underwriting was valuable? What kind of information captured their attention?

In a recently published study, I addressed these questions by exploring how 268 U.S. investment and commercial banks responded to the CDO underwriting behavior of their peers, focusing on the years leading up to the credit crisis (1996-2007).

Learning from external examples

How do firms make decisions about which activities and strategies to pursue? Scholars have long recognized that no firm is an island: when making decisions, companies often turn to examples from those around them for clues about how to proceed. Yet despite a very large and active literature on how practices spread, we know surprisingly little about what, exactly, firms learn from these external examples.

We have yet to sufficiently answer a very basic question: do firms attend to the prevalence of an innovation or to the results obtained by earlier adopters?

Institutional theorists and learning theorists have provided different answers to this question. Institutionalists, who focus on the role of social pressure in spurring diffusion, predict that firms will embrace innovations that have proven popular with others. Learning theorists, who focus on the effects of performance feedback, predict that firms will embrace innovations that have been shown to work for others.

Scholars from each camp have criticized the theoretical emphasis (and empirical strategies) of the other. Learning theorists have argued that a vision of diffusion as driven solely by copying popular practices is unrealistic in a world where managers are evaluated on performance. Institutionalists, in turn, have noted that managers in competitive markets often struggle to observe the true performance effects of innovation use at other firms, since firms rarely share private performance information with competitors.

Learning from loosely-linked evidence

I introduce a novel mechanism of social contagion that takes both considerations into account. While it is true that banks could not easily observe the true performance effects of CDO underwriting at other banks, I do not expect them to blindly emulate the activities of other underwriters. Instead, I find that banks learn superstitiously from loosely-linked performance evidence, responding to general impressions of “how well other CDO underwriters are doing” on broad performance metrics like share price or profitability.

“Superstitious” learning occurs when actors attribute outcomes to recent actions that may not have caused the outcomes, as when firms embrace an activity because it co-occurred with favorable performance, regardless of whether it actually contributed to this outcome. Performance on broad metrics like share price or profitability may not be driven by the use of specific innovations, but these are the measures that banks can observe. And when this is the performance information that banks have, I expect that they will learn from it.

Using event history models of every CDO underwritten by a publicly-traded bank, I show that banks responded to the share price performance of other CDO underwriters – even though share price performance was a poor proxy for the true performance effect of underwriting CDOs. In short, banks learned superstitiously from the share price performance of other recent underwriters, underwriting more CDOs when other underwriters appeared to be performing well, and underwriting fewer CDOs when other underwriters appeared to be performing poorly.

I also show that what banks learned from observing other underwriters changed with the popularity of CDO underwriting. As underwriting CDOs became an increasingly popular activity, I find that banks grew even more attentive to confirmatory (but not contradictory) evidence about share price performance. After CDO underwriting became an established and legitimate practice, bank managers were more likely to respond to evidence of strong share price performance among recent underwriters – but not evidence of poor share price performance. In short, learning from performance became more selective as the activity became more popular.

Taken together, these findings offer a new take on how social institutions operate to structure strategic behavior in a messy and complex world, in which the true performance effect of an innovation is frequently unobservable to others. The implication is that while firms in competitive markets may not blindly mimic popular practices, the institutionalization of the practice does shape the kind of evidence that catches their eye.

Extraordinary consequences, ordinary processes

The rise and spread of CDOs in the American financial system had extraordinary (and devastating) consequences. It makes sense that extant accounts of the diffusion of these risky financial instruments have focused on the characteristics that made CDOs so different and unique. But I suggest that CDOs can also be thought of as just another innovation that diffused through ordinary organizational processes.

In focusing on ordinary processes in an extraordinary context, I uncover an additional, overlooked contributor to the credit crisis: what, and how, banks learned from the performance outcomes of others. An implication is that as long as CDO underwriting was viewed as a legitimate or effective practice, and as long as other CDO underwriters continued to see strong share price performance, internal market dynamics alone could have propelled the explosive growth in CDO underwriting that took place between 2003 and 2007.

A focus on share price

A natural follow-up question is why banks were so focused on the share price perfor­mance of other CDO underwriters (I also test whether banks responded to other broad and general measures of CDO underwriter performance, like book profitability, and find that they did not).

Prior research has linked extreme focus on market performance to the rise of a new model of corporate governance, shareholder value management. Before the late 1970s, most investment banks were still privately held partnerships, and most commercial banks still engaged in traditional banking. But as shareholder value management gained traction in both industrial and financial circles, firms started to implement compensation practices that rewarded a single-minded focus on share price, and pursued riskier strategies to generate larger returns. Almost a decade out from the crisis, these prac­tices and strategies have hardly changed, prompting the question of what will happen the next time a hot new innovation coincides with strong market perfor­mance.

Kim Pernell-Gallagher will be an Assistant Professor of Sociology at the University of Toronto, starting July 2016. This post summarizes findings from “Learning from Performance: Banks, Collateralized Debt Obligations, and the Credit Crisis” in the journal Social Forces.

Image: Rafael Matsunaga via Flickr (CC BY 2.0)

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