Case 7: Blind or incompetent? Perhaps both…
"Believing we are right" has led to bad outcomes, sometimes even spectacularly bad results, for leaders, teams and organizations.
For my book, BIG DECISIONS: 40 disastrous decisions and thousands of research studies tell us how to make a great decision when it really matters, I identified and categorized nearly 350 mental traps and errors that lead us into making bad decisions. The many high-profile situations that I examined demonstrate the bad outcomes that can be produced by mental traps and errors. My premise is that, at the least, if we recognize and admit that we don't know the answer, we will put more effort into looking for better decision options and limiting the risks stemming from failure when making important decisions.
In this case, a CEO led his firm - and some would say the entire country - over the financial precipice by escalating its reliance on risky financial instruments.
Doubling down
Lehman Brothers CEO Richard Fuld believed that the investment bank was adequately capitalized when it increased its leverage from 12-1 to 40-to-1, became a major player in securitizing subprime mortgages, relied on risky credit default swaps for protection, and engaged in accounting maneuvers that disguised how much debt the firm had taken on. Also, he believed that the U.S. government would bail out the firm when the policies and actions he enabled put the firm on the brink of failure in 2008.[1]
Contrary to Fuld's belief, Lehman Brothers was woefully undercapitalized as the financial crisis arose. The federal government walked away from a "too big to fail" tag that Fuld and others thought would be applied to the firm. Lehman Brothers failed. Fuld was disgraced.
Fuld's assuredness that his way was the road to great success for Lehman Brothers and that the U.S. government would backstop the firm suggests his incompetence, that he was captured by the Dunning–Kruger effect. In this trap, incompetent people often overestimate their abilities, competencies and characteristics and consider themselves more competent than others: They can't see their incompetence because they lack the skill to distinguish between competence and incompetence.
Likewise, as a veteran of the investment business and firm leader, Fuld likely was waylaid by epistemic arrogance. This bias arises, wrote Nassim Nicholas Taleb, because “as we learn more, our confidence in what we know grows and we underestimate uncertainty.”[2] We are unaware of the limits of our knowledge. Fuld seemed to have thought that he knew enough about credit default swaps and how the government would treat a firm like his in a crisis to be relatively certain that his strategy would prevail. He fell into the trap of overestimating what he knew and underestimating uncertainty.
Further, evidence suggests that Fuld was trapped by egocentric bias, our tendency to rely too heavily on our own perspective, and to claim more success and have a higher opinion of oneself than reality would confirm are appropriate. We need to boost our ego. This gets in the way of clear-eyed assessment and understanding, which Fuld did not demonstrate.
Other mental traps mentioned elsewhere in this book jump out in Fuld's folly:
Not having a sense that he was betting the life of the firm by taking on so much leverage and dealing in subprime mortgages and credit default swaps is a classic example of risk blindness (having the potential rewards of taking a risk obscuring the downside, ignoring the probability of adverse outcomes).
As the firm's bottom line became more dependent on securitizing subprime mortgages, Fuld kept upping the firm's involvement with the instruments even as it became increasing clear how risky they were. Fuld and his lieutenants thereby demonstrated escalation of commitment (the tendency for people to justify increased investment in a decision based on the cumulative prior investment, despite new evidence that suggests that the current cost of continuing the investment outweighs the expected benefit).
Having the firm take on more and more debt and leverage to try to push it to the top of firms dealing in securitized sub-prime mortgages, Fuld clearly was trying to force a solution to the situation at hand, falling into the force can do it trap. In retrospect, force could not solve the firm’s immense debt problem.
Sources
[1] https://en.wikipedia.org/wiki/Bankruptcy_of_Lehman_Brothers
[2] Taleb, N, N. (May 11, 2010). The Black Swan: Second Edition: The Impact of the Highly Improbable: With a new section: “On Robustness and Fragility. Random House Trade
