Although the so-called bailout bill has been passed by Congress and signed by President Bush, everyone is ready to point fingers at someone they can blame for the crisis. If we can simply blame someone, we can feel better because we think we can know what to watch for next time.
I cannot say that I know the ultimate cause of this situation nor who was responsible for it. (Although, you will find some good economic discussion of it here) I do know with certainty, however, what made it possible: faulty assumptions. Nearly every player in the mess made assumptions about what they thought would happen and for the most part, ignored evidence that went counter to their assumptions. After they were in too deep, they failed to review their assumptions, or perhaps were in too deep to do anything but simply take it. They were left to hope that their best case assumptions could eventually save them.
Here are some examples of the assumptions I am talking about:
- Lenders assumed that real estate values would continue to increase indefinitely. Otherwise, why lend 100% of the equity of a home? They also assumed that a homeowner would never walk away from a home. After all, people want to pursue the time-honored American Dream of home ownership. But when homeowners who bought homes for $225,000 and a mortgage of 200K or more saw their home values fall to $150,000, why wouldn't they exercise their put option and give the collateral back to the lender?
- Homeowners assumed that their incomes and home values would rise indefinitely. Otherwise, why borrow 100% of your equity? In some cases, it was a matter of keeping up with the Joneses. When 5 people work in an office together and all have basically the same job, how is it possible that one of them can afford a house that is 3x the value of their peers? An inheritance? Astute investing in tech stocks? Others were simply grateful for the opportunity to own their first home and did not know what assumptions to even question.
- Investment bankers assumed that if you divided the mortgages into components, you could spread risk and create new value for investors by providing a new way to earn return and manage risk. But what happens when the assumed default rates are far higher than expected - and you can't reconstruct the mortgage to find out who is responsible for what? What happens when you sit down and figure out that you have essentially created effective leverage of better than 25:1? (By contrast, most of us can buy stock on margin at a maximum of 2:1)
- Investors believed that the mortgage brokers were following standards, that collateral values meant something and that appraisers could discern value. Of course, now we hear the stories about bankers who told the appraisers what the "right" number should be.
- Politicians assumed that pumping more mortgage money into sub-prime loans was more important than concerns about the financial condition of Fannie Mae and Freddie Mac. When Ginnie Mae and Freddie Mac were found to have some accounting irregularities, Congress rightfully asked why these agencies should be given the power they have. Their benefit to Americans? Lower mortgage costs for those who otherwise could not afford a mortgage. After Congressional hearings, the agencies immediately increased their market purchases of sub-prime loans.
- Speculators thought that we were on the brink of a totally new economic model. People were flipping Florida condos with huge gains in months, rather than years. Even though new units were being built, there was no way that retirees would stop moving to the coasts! Then along come a series of hurricanes and the "half-back" phenomenon.
- "Conservative" borrowers assumed this was all good for them, too. If you were working to pay down your mortgage, you didn't mind what was going on too much because your home value was exploding! You thought you had made one of the best investment decisions ever. Even if you weren't ready to sell, it was nice to see the balance sheet numbers get bigger!
So who is the "evil doer" in all of this? Just about everyone displayed a combination of trust and self-interest, in varying degrees. When your neighbor or competitor is making it big, it is easy to get caught up in the excitement and lose perspective, isn't it? And yes, there were some unscrupulous and arrogant players, to be sure. And to some extent, a system that is made up of players who are primarily compensated solely on commissions (for selling, financing, underwriting, appraising, etc.) and not on performance of the underlying loan, you are playing a risky game.
But when you step back, you see an entire system in which most of its players made assumptions that proved to be incorrect. We reached a condition of irrational exuberance that had very painful consequences when the assumptios unraveled.
So how about you, for your business, what assumptions are you making? Here is a simple process for checking and managing your assumptions:
- What assumptions are you making now about your business - what your employees, partners, customers, suppliers and competitors are doing and will do?
- Of those assumptions, which are the most critical? Of, let's say, 30 key assumptions that you are betting your business on, which 5 matter most?
- How will you test and monitor those key assumptions? What will tell you that you are being conservative and that the opportunity is far greater than you believed? What will tell you that you are being overly optimistic, that you are assuming facts that are simply not true?
- What will be your early sensing mechanism? What will you watch and listen for that will give you an indication that your assumptions may be wrong - and that it is time to rethink your assumptions?
- Who will be responsible? Whose job will it be to monitor each of your key assumptions and recommend adjustments?
Next time you get your team together to plan an important project - or check the status of an existing initiative, be sure to check your assumptions. Make this thinking part of your strategic planning, customer planning and campaign planning.
While politicians cannot always speak with candor, your success depends on the candor and discipline you bring to managing and rethinking your assumptions.
