The Poster Child of Overconfidence and Greed: Reflecting on Lehman Brothers 15 Years Later

by | Sep 15, 2023

Lehman Brothers failed 15 years ago today. The Financial Crisis had been brewing for over 18 months, but Lehman’s collapse was an epochal event that brought the global financial system to the brink of collapse.

The root of Lehman’s failure was excessive risk-taking. It was highly leveraged at over 30:1, and some analysts believe Lehman was actually levered 44:1. That means that for every $44 of assets they had, there was only $1 to cover losses, so a small decline in asset value would wipe out the firm’s equity. And that’s what happened. Lehman heavily invested in mortgage-related securities and when the housing bubble burst, it suffered massive losses and its capital was wiped out.

Why would Lehman over-leverage itself and concentrate its investments in one sector of the economy? It boils down to overconfidence and greed: Lehman thought it had a grip on the risks in the housing market (it was wrong), and making big bets and being highly levered made the firm boatloads of money.

While Lehman Brothers was the poster child of the misplaced hubris and risk-taking that characterized the era, it wasn’t alone. Bear Stearns, another large investment bank, was on the brink of failure when JP Morgan bought it for $2/share six months earlier. And shortly after Lehman’s collapse Merrill Lynch was merged into Bank of America via a shotgun wedding and Goldman Sachs and Morgan Stanley became bank holding companies so they could access funding from the Federal Reserve. All the big investment banks were overconfident and greedy.

Lehman’s collapse and the Financial Crisis provide a valuable lesson: overconfidence and greed are powerful, dangerous traits that we must battle against in ourselves and watch out for in others.

In my book, The Uncertainty Solution, I dig into overconfidence and its deleterious effects. Here’s an excerpt from my book where I introduce the topic and how recognizing overconfidence can make us better investors:

My colleague, Carl, is a horrible driver. Every time I ride with him, I feel like I’m putting my life at risk. He drifts out of his lane, tailgates, rarely uses his signals, and drives too fast. But when we travel together to see clients, he insists on driving our rental car. After a particularly harrowing trip back to the airport, I asked him how he’d rate his driving.

“I’m a great driver,” he said emphatically, a bit put out that I’d asked. Carl truly believed it. He had no doubts.

Carl isn’t alone in this. Studies have consistently found that the vast majority of drivers rank themselves very highly. A 1981 survey of American drivers found that 93 percent put themselves in the top 50 percent of driving ability. My favorite study is from 1965. Researchers surveyed one hundred drivers, fifty of whom were in the hospital with injuries from car crashes. The other fifty had spotless driving records. You know what comes next. Based on their self-ratings, the two groups were indistinguishable. On a continuum of skill, both groups judged themselves closer to expert drivers than poor drivers. Police reports on the hospitalized drivers found that thirty-four of these driving experts were responsible for their accidents.

It’s ludicrous that injured drivers who caused their own accidents would be as confident in their driving ability as those with spotless records, but that’s how humans are wired: we’re all overconfident. We see ourselves through rose-colored glasses. For example:

  • We tend to think that we’re better than we are: that we’re smarter, better looking, and more fun and likable than is true.
  • We think we’re better than others. In competitive situations, we tend to think of ourselves, our company, our team, etc., as relatively better than other people, companies, and teams.
  • We think our futures are brighter than other people’s futures.
  • We think we know more than we really do. As a result, we make predictions of the future and think they’re more accurate than they turn out be.
  • We think we have more control over our lives than we really do.

Daniel Kahneman says that overconfidence is the bias he’d most like to change if he had a magic wand. In their textbook on decision making, Max Bazerman of Harvard and Don Moore of the University of California, Berkeley call overconfidence the “mother of all biases” and blame overconfidence for “wars, stock market bubbles, strikes, unnecessary lawsuits, high rates of entrepreneurial bankruptcy, and the failures of corporate mergers and acquisitions.” Arguably, Russia’s invasion of Ukraine in early 2022 was due to overconfidence—Putin and his generals reportedly thought the war would last days, overestimating their own military prowess while simultaneously underestimating Ukraine’s resolve. Additionally, Chernobyl, the Challenger explosion, the invasion of Iraq, and the sub-prime mortgage crisis can all be traced to overconfidence.

1 Comment

  1. There is zero chance that a Lehman situation will ever occur in the future 🙂


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