Case 7: Blind or incompetent? Perhaps both…

OTD September 15 - Lehman Brothers_27378854_3963195_ver1.0_640_360

This post is number six in my series looking at cases where it seems that “believing we are right” has led to bad outcomes, sometimes even spectacularly bad results, for leaders, teams and organizations.

For my upcoming book, Big Decisions: Why we make decisions that matter so poorly. How we can make them better, I have identified and categorized nearly 350 mental traps and errors that lead us into making bad decisions. The many high-profile situations that I have 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 had enabled put the firm on the brink of failure in 2008.

Contrary to Fuld’s belief, Lehman Brothers was woefully undercapitalized as the financial crisis arose. The federal government walked away from an implicit “too big to fail” tag that Fuld and others thought would be applied to the firm. Lehman Brothers failed and Fuld was disgraced.

Three big mental traps jump out of 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).
  • 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 (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).

The lure of huge rewards can warp our sense of risk. We tend to overstretch to attain them. We don’t see that our judgment is altered and therefore our decisions are more likely to go bad because they entail taking excessive risk.