This is Part 1 of a 2-part article on the human cognition of risk and debt. The second part can be found here.

In her textbook Neuroeconomics and the Firm, Angela A. Stanton quotes psychiatrist and former trader Richard Peterson, who tells us the story of Lee:

Lee [was] a 53-year-old partner in an accounting firm, who lost part of his Orbitofrontal Cortex (OFC) as a result of surgery to remove a tumor…

After a successful operation, Lee was able to return to work and function normally except for his terrible investment decisions. He bought several expensive vacation time shares, bought penny stocks based on faxed and emailed promotional material and could not keep up his mortgage payments. The loss of his OFC took away an important part of Lee’s functional ‘loss avoidance’ system. Previously a conservative investor, he was now unable to feel ‘risk.’ Lee explained that he knew he should feel uncertain and afraid, but his highly speculative investments did not feel ‘risky’ to him.

America is a nation engorged on debt. Many of us need ten years or more to pay off hefty student loans. Many others of us never fully recover from getting too deep into credit card debt. Still others of us took mortgage debt on terms we couldn’t afford because we planned on refinancing before it became a problem.

Market theory tells us that supply and demand forces will place a rational value on debt risk. A debtor fitting such-and-such a profile, with so much collateral, borrowing for so long a time equals a precise interest cost. Of course, the future is not completely foreseeable, and there’s always a risk that the borrower will not be able to pay the loan back. But the market has baked that possibility into the cost of the loan…that’s the whole point. Therefore – as far as the market is concerned – debt is a knowable, quantifiable entity.

And yet, every major financial crisis in the history of the United States has been either precipitated or exacerbated by over-leveraging. Investors and banks have borrowed to finance investments since Aristotle’s time. Yet we find ourselves living through more and more periods of financial turmoil, usually kicked off by over-leveraged or unwisely-leveraged professional investors.

Preceding the 1929 crash, investors were buying stocks on as much as 90% margin (nine dollars of loan to every one dollar of capital). Starting in 1975, the maximum debt-to-equity ratio for investment banks was 12-1 (it could borrow up to 12 times its own net worth to play the market). When the rule was relaxed in 2004, those ratios went up to 30-1 and even 40-1. At the time of its crash, the Swiss bank UBS was leveraged at 60-1. The Long Term Capital Management hedge fund, at its 1998 bailout, had an effective leverage ratio of 250-1. These outlandish leverage rates were a major contributing factor to the 2007 financial crisis.

So if the major aspects of debt risks are so quantifiable – if you can know the terms and rationally determine the risks to which you will be exposed – why does debt consistently get us into so much trouble?

Not surprisingly, the answer is psychological. Human beings do not make rational decisions about debt. Our brains were designed to make judgments based on what we have or what we don’t have. That is a positive, concrete idea: “I own one car, and my neighbor owns three cars. I can see the evidence of that right in our driveways.”

Our brains never evolved as effective a mechanism for evaluating what we owe, which is a much more abstract cognition.

When we take on debt, we rely on the brain’s loss-avoidance systems to provide them with the necessary feelings of fear and pain that guide what ends up being a very emotional judgment. Additionally, there are a number of cognitive distortions that can bypass this mechanism, allowing us to marginalize the mental warnings that we’re putting ourselves in danger.

These mechanisms and biases are all evident in the lead-up to the 2007 financial crisis, and so we will look at many examples relating to the crisis as we explore these ideas.

Detached Loss-aversion

There is so much going on in our heads when we conceptualize debt and risk, that I had to break this article into two parts. In this first part, I’m going to talk about Loss-aversion, the central mechanism against imprudent risk.

The active brain center for this mechanism lies in the Oribitofrontal Cortex (the portion that Lee had removed during his tumor surgery). According to the textbook cited earlier, the scientists who study this part of the brain believe that this mechanism is a homeostatic system. That means it creates a negative response when it is out of balance, and a positive response when it returns to balance.

We start at a point of balance, and are then pushed off that point by the desire or fear of something. The system manufactures anxiety. When we have attained the needed thing or avoided the fearful thing, we feel pleasure, and a release of tension. That pleasurable sensation is an “‘informational signal’ that we are moving in the right direction…[back to balance].”

Now, what if you could feel the sensations of desire, but not the frightening danger signals of risk? Potentially, you would behave like Lee, in a manner oblivious to potential risk. Except you don’t have to have part of your brain removed for this to happen. It’s happening constantly.

If your instinctual aversion to loss becomes “detached” from the transaction, you will not feel emotionally apprehensive when you take on risk. This is exactly what happens when you purchase on credit: you feel the pain of loss some other time, if at all. If you carry a balance, that balance could start to feel like an abstract number – something you live with long term, because it doesn’t register as pain until you max out. And if you gradually increase your indebtedness over time, like a frog sitting in slowly-heating water, you won’t feel it until you’re boiling.

Detached loss-aversion contributed greatly to the 2007 financial crisis, and on many levels. Collateralized debt (i.e. tradable mortgages) are designed to take all the debt risk away from mortgage originators and sell it off to others. Therefore, originators no longer care about the credit-worthiness of borrowers; they feel no pain if the borrower defaults.

When investors purchased the AAA-rated CDOs, they believed that they were getting a risk-free return. What little risk they believed to be involved, they hedged against by purchasing Credit Default Swaps (a kind of insurance where, ironically, the insurance company doesn’t keep any reserve cash on hand to cover losses). If the securities were unrated, or rated at a level commensurate with their actual risks, investors would have felt a great deal of apprehension. But the AAA ratings switched off the investors’ sense of loss-aversion. They felt no pain.

In 2004, when the net capital rule was relaxed, investment banks started piling on as much leverage as they could buy. If there had been no financial crisis, that leverage growth would have continued, because the markets would have been increasingly willing to lend them more and more money. None of the investment banks showed external signs of weakness until they suddenly collapsed, so neither lender nor borrower felt any sense of pain. After all, if everything’s working fine at 40-1, why not 80-1? Why not 500-1? How many trillions of interconnected investments would have become instantly worthless in that crash?

We owe our ability to evaluate debt-related risks not to some carefully thought out calculation, but to a complicated, subjective, suggestible emotional response…a response that varies from person to person, depending on experience, mental health, and DNA.  Marketers and salesmen do everything that they can to make transactions as “pain-free” as possible. Tools like no-interest financing and electronic payment systems are designed to bypass the wiring in your brain that keeps you safe.

Pain is Good

In the book All The Devils Are Here, authors Bethany McLean and Joe Nocera detail the egregious predatory lending practices of subprime mortgage originators like Ameriquest. However, this psychological data suggests that lenders do not have to engage in fraud or predatory practices in order to get borrowers to overextend themselves.

We have proven that we can easily rationalize adding risk if it comes in seemingly small monthly payments. Absent any visceral pain from the fear of overextension, our rational brains get clever and start to over-think. “Sure I can add this cost…my bonus will cover it. My stock options will be in the money by then. My home value will have increased by another 10%. It’ll be fine.” I’ll talk more about how we rationalize these things in Part 2.

The same impulse that caused banks to leverage themselves at 40-1, got us all overextended in our mortgage debt. I have slightly more sympathy for the individuals rather than the investment banks, because some of these originators built entire business models on suckering their clients (many of whom were undereducated). Traditionally, banks would never give you a lone that you couldn’t pay back, because they’d be stuck with the default. Now that they can sell off the risk, they couldn’t care less.

This is to say that we are now in an era where you are officially the only one representing your own financial interests. Mortgage originators, car finance originators, credit card companies, investment bankers, realtors, and real estate lawyers (even the ones working for you) all just want the transaction to get done. It is no longer their job to take into account whether or not you can handle what you’re getting into, because it’s no longer their problem. Instead, they will all apply pressure to make the transaction happen.

The sensation of trouble – the pain response that’s a part of Loss-aversion – will only be a whisper at this point. And the other people in the room will be doing whatever they can to make sure you don’t hear it. But that small whisper is all that’s left of the psychological mechanisms designed to save you, so embrace it and listen for it. Sometimes, pain is a good thing.

Part 2…

In addition to bypassed or detached loss-aversion, there are at least ten or twelve other cognitive biases that also interfere with our ability to evaluate debt risk. I will talk about those in detail in Part 2, and I will also talk about the things we can do to prevent debt from screwing with our heads.

Go on to Part 2: Distortion and Bias.