The 2008 Mortgage Crisis as a Failure of Analogical Reasoning

Abstract

Managers’ mental models play an important role in shaping a firm’s competitive advantage. This paper suggests that persistent mental models or cognitive frames can have negative consequences at the individual, organizational, and industry levels. Specifically, the paper proposes a mechanism by which cognitive frames generated with the help of analogical reasoning persist by inducing analogical blindness, forcing decision-makers to disregard information at odds with the analogy. To date, analogical reasoning has been studied mostly in cross-sectional experimental settings. Consequently, little is known about the performance of analogical reasoning over time. The contribution of this paper is to document the persistence of mental models generated by analogical reasoning over time with decision-makers discarding data from the external environment to preserve their belief in the analogy in question. The paper uses a longitudinal case study of the market for mortgage-backed securities in the U.S. between 1968 and 2008 to trace the role of ‘mortgage-backed securities as bonds’ analogy in the development of the market from its inception to its demise. The paper argues that in evaluating an analogy, the decision-makers should consider the possible long-term consequences of the analogy’s acceptance. ∗Acknowledgements. I thank Adam Brandenburger, Viral Acharya, Graham Allison, Michel Anteby, Yakov Amihud, Daniel Beunza, Matthew Bidwell, Ryan Booth, Lera Boroditsky, Marcelo Bucheli, Olivier Chatain, Gabriela Coiculescu, Rob Cocca, Jerry Davis, Joyee Deb, Emilie Feldman, Amanda Friedenberg, Price Fishback, Chris Foote, Jeff Fuhrman, Giovanni Gavetti, Dedre Gentner, Brent Goldfarb, Mauro Guillen, Rena Henderson, Vincent Hendricks, Patricia Hewlin, Kose John, John Joseph, Aimee Kane, Michael Katz, Zack Kertcher, Pierfrancesco La Mura, Maggie Levenstein, Natalia Levina, Dan Levinthal, Elliot Lipnowski, Donald MacKenzie, Jim March, Luis Martins, Bill McEvily, Anita McGahan, Chris McKenna, Justin Miller, Frances Milliken, Ethan Mollick, David Obstfeld, Sanjay Patnaik, David Pearce, Lamar Pierce, Woody Powell, Mary Rodgers, Renee Rottner, Arkadiy Sakhartov, Anthony Saunders, Kenneth Snowden, Gabriel Szulanski, Zur Shapira, Nicolaj Siggelkow, Richard Sylla, Neil Trenk, Stijn van Nieuwerburgh, Artem Voronov, Dan Wadhwani, Shellwyn Weston, Sara Wheeler-Smith, Gene White, Larry White, Sid Winter, Caitlin Zaloom, Mark Zbaracki, seminar participants at Higher School of Economics, NYU Stern, NYU Wagner, Rutgers-Camden, Tuck School, Wharton School, Association of Business Historians, NBER Summer Institute, Organization Science Winter Conference, Oxford Journals Doctoral Colloquium for Business History, and London Transatlantic Doctoral Conference for their helpful comments. All mistakes are my own. †The Wharton School, University of Pennsylvannia, natalyav@wharton.upenn.edu Understanding managers’ mental models and how these mental models shape how organizations perceive their environments is fundamental to the field of strategy (Gavetti [38, 2012], Karnoe & Garud [36, 2003], Daft & Weick [15, 1984]). Managers’ mental models shape how managers frame a given problem and this framing, in turn, shapes organizational action. Managerial framing is subject of a growing vibrant literature (e.g., Benner & Tripsas [8, 2012], Kaplan [67, 2008b], Lounsbury, Ventresca & Hirsch [76, 2003]). The questions of what happens when managerial cognitive maps become obsolete and what effect such obsolescence has on the firm’s performance have received less attention in the literature. Kaplan [66, 2008a] models the managerial framing process as dynamic and contestable. But a growing body of evidence suggests that cognitive frames remain stable over time. For instance, Tripsas [110, 2009] argues that organizational identity contributes to the stability of organizational beliefs. Moreover, this stability can lead to negative outcomes for the firms in question. Tripsas and Gavetti [111, 2000] document the role of persistent managerial beliefs in Polaroid’s failure to respond to changes in its environment. This paper focuses on analogical reasoning as one source of persistent cognitive frames. The paper’s contribution is to build on the current knowledge about the cognitive processes underlying analogical reasoning and lay out a theoretical framework that explains why cognitive frames generated by analogical reasoning may persist over time and how this persistence may blind decisionmakers to changes in their environments. The empirical setting of this paper is the evolution of the market for mortgage-backed securities (MBS) in the U.S. from the market’s inception in 1968 to the 2008 contraction of the market in which more than 3 million families faced the risk of foreclosure. I used a combination of interviews and archival sources to construct a 40-year analytical history of the ‘mortgage-backed securities as bonds’ analogy which shaped the introduction of MBS and played a key role in the development of the market. By showing that an analogy laid out consistently with the best recommendations for static decision-making can lead the decision-makers astray, this paper offers a boundary condition to the current understanding of analogical reasoning in organizations.

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