Loss aversion and finding a bottom

About five years ago, Daniel Kahnemann won the Nobel Prize in Economics for his work on Behavioral Economics. This was a breakthrough because the financial markets and the economics profession had been dominated by the “efficient market,” laissez-faire, no-regulation crowd for some time.

His theories go a long way toward explaining why the credit unwind process will be both long and painful.

Loss aversion by Kahnemann
Let’s look at Human nature and loss aversion and see what this tells us about what is happening right now.

In an oft-cited experiment, the psychologists asked a group of subjects to imagine the outbreak of an unusual disease, expected to kill 600 people, and to choose between two public health programs to combat it.

Program A, the subjects were told, had a 100 percent chance of saving 200 lives. Program B had a one-third chance of saving 600 lives and a two-thirds probability of saving no lives.

Offered this choice, most of the subjects preferred certainty, selecting Program A.

But when the identical outcomes were framed in terms of lives lost, the subjects behaved differently. Informed that if Program A were adopted, 400 people would die, while Program B carried a one-third probability that no one would die and a two-thirds probability that 600 people would die, most subjects chose the less-certain alternative.

Interview with Daniel Kahnemann, NY Times, 5 Nov 2002

Here, we have the exact same scenario presented in two different ways: first in terms of potential gains, then in terms of potential losses. Basically, what Kahnemann’s experiment tells us is that framing the context of loss or gain is very important in incentivizing economic actors. People will prefer risk to caution in order to prevent a loss, but will prefer caution to risk in order to lock in a gain.

Loss aversion in housing
In the context of the housing bubble, this conclusion is very important. It means that people will fight tooth and nail to prevent themselves from taking a loss. Let me make this clear with a Kahnemann-like example:

Let’s say the average person with a mortgage has a home that was worth $300,000, with an average equity of $120,000, leaving them with an average mortgage of $180,000.

In Housing Bust Option A, their houses will decline in value to $240,000. The subjects are told they have a 100 percent chance of saving half their housing equity. Housing Bust Option B gives the subjects a one-third chance of saving 90% of their housing equity as their house value only falls by 4% to $288,000 and a two-thirds probability of saving 30% of their housing equity as their house value falls to $216,000.

Offered this choice, most of the subjects would prefer certainty, selecting Housing Bust Option A. After all, losing 70% of one’s equity doesn’t sound that appealing.

But what if the identical outcomes were framed in terms of equity lost? What would homeowners do then? The subjects would behave differently, just like in Kahnemann’s example.

Informed that in Housing Bust Option A were adopted, half of their home equity would be wiped out, while Bust Option B carried a one-third probability that only 10% would disappear and a two-thirds probability that 70% would disappear, most subjects would choose the less-certain alternative and gamble.

Framing the housing debate
Today, most people have framed house sale transactions in terms of losses or falls from peak prices. Remember, a short while ago we were being told that housing prices NEVER fall. At the housing bubble’s peak, most people certainly thought that the gains they had made in their homes were a sure thing. People mentally locked in those gains and went and spent that money using the housing ATM.

What this certainly means is that people would prefer to pull their houses off the market and risk further falls in home prices than accept a certain loss today. This is a principal reason that transaction volume falls well ahead of prices when housing busts occur. As transaction volumes are still declining, this bust has much further to go before we find a bottom.

Moreover, this mindset increases political pressure to forestall the fall of house prices to a ‘market clearing level.’ If you are a politician and your constituency is telling you that the equity in their homes is being eroded and that you had better do something, you are definitely going to look to stop that price erosion. No politician with half a brain is going to advocate letting prices drop so the market can clear. People just wouldn’t understand that logic. That is what the U.S. housing bailout is all about.

So, we have a housing market that will be propped up two-fold — through homeowner loss aversion in reducing the number of transactions and through political interference to prevent losses to the political constituency.

What loss aversion means to the financial system
This same aversion to loss will ultimately undermine the strength of the banking system. When Merill Lynch sold $30 billion of distressed mortgage-related paper in a vendor-financed sale for 22 cents on the dollar, it was acknowledging the same loss aversion has been keeping financial institutions from writing down more debt.

Commentators who ask why financial institutions keep writing down more and more credit don’t understand the psychology of loss aversion. Clearly, those who run banks and hold these mortgage-related securities are people too — with the same emotions as everybody else. They have been waiting for the crisis to blow over so that they won’t have to book a loss.

In the meantime, everyone else eyes these institutions with suspicion, knowing they have hundreds of billions of dollars in toxic securities left to unload. This leaves the credit markets damaged and creates systemic financial risk.

Conclusion
We won’t find a bottom until distressed homeowners and investors alike are forced to sell assets into the market at market clearing prices. And those prices are perhaps some 20-30% below where we are today in terms of home values and related financial assets. Ultimately, this means that we will need to see much more distress both in terms of the macro economy and the financial system before markets will clear.

I anticipate that we will coast along, avoiding the pain until the collapse of a major financial market player and true economic recession which herald market clearing prices in housing and financial assets. Until then, loss aversion will be the driving emotion for homeowners, politicians and financial institutions alike.

Expect a long, drawn out conclusion to this crisis that is now almost one year old. The same dynamic that prevented Japan from biting the bullet in the 1990s is alive and well in this global housing bust.

Addendum
The term loss aversion is also explained at Wikipedia with special mention of Kahnemann. Here is a particularly telling blurb from that entry:

Loss aversion was first proposed as an explanation for the endowment effect – the fact that people place a higher value on a good that they own than on an identical good that they do not own – by Kahneman, Knetsch, and Thaler (1990) [2]. Loss aversion and the endowment effect lead to a violation of the Coase theorem – that “the allocation of resources will be independent of the assignment of property rights when costless trades
are possible”
Loss Aversion: Wikipedia

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.