We all love a good story. Stories have been an important method of understanding our world since we were toddlers. It doesn’t end there. We are life-long narrators. It turns out that we remember things more easily if they are in the form of a story or narrative rather than as unconnected fragments of information. We appear to have a hardwired need to develop narratives to impose order and find causality in the past and present, even in situations that lack them. Unfortunately, these narratives often result in selective memory, distortion of the past and manipulation of facts.
Also, investment managers take advantage of these human traits in order to market their products.
Nobel Prize winner Rober Shiller describes narratives as follows: "I use the term narrative to mean a simple story or easily expressed explanation of events that many people want to bring up in conversation or on news or social media because it can be used to stimulate the concerns or emotions of others, and/or because it appears to advance self-interest."
Shiller has written an extensive article on the role of narratives in causing economic events, including depressions, recessions, bubbles, panics, etc. (Narrative Economics, January, 2017). For example, Shiller states that "we have to consider the possibility that sometimes the dominant reason why a recession is severe is related to the prevalence and vividness of certain stories, not the purely economic feedback or multipliers that economists love to model."
The Narrative Fallacy in behavioral finance occurs when we assume a connection between elements that may not be connected. For example, touting a mutual fund’s prior performance as a guide to its future performance. In the world of finance, narratives run rampant. Every product is sold using a narrative. Analysts produce narratives as do companies in statements and annual reports. We rarely see a financial analysis or projection that is not embedded in a narrative.
Unfortunately, narratives often serve to distract us, distort the underlying reality, or manipulate us into making decisions based on them. A narrative that includes connections and causalities that are not grounded in facts can easily lead to poor trading and investment decisions.
One way of saving us from the potential downside of narratives is what I call the Narrative Audit™. The Audit dissects the narrative on a security or investment into its factual and non-factual components allowing us to analyze and interpret the factual component and ignore the imputed causality provided by the narrative. Not that the latter are necessarily disregarded, but they are often embedded in misleading conjecture or causality.
The points are illustrated by a Narrative Audit of the claims used to justify the sale of subprime mortgage backed securities (MBS) in the lead-up to the credit crisis of 2008. I focus on MBS that were sold between 2006-8 to investors ranging from individuals to pension plans to government entities.
The MBS Narrative
The overarching narrative used to market MBS securities went as follows: “Subprime MBS are an excellent investment because of their high yield and low risk, which are supported by the rising price of housing and the waterfall structure of MBS securities." (Narratives, such as those associated with Ponzi schemes, often deny the well-known trade-off between risk and reward by presenting an investment that has both high yield and low risk.)
1. Rising Price of Housing The MBS’ risk, goes the narrative, is contained (or eliminated) because the mortgages are collateralized by houses; and the price of houses has risen sharply over the past few years and will continue to rise in the future. One narrative justifies the future rise in house prices to the fact that the supply of houses is limited because “they don’t make land anymore.”
A “logical” conclusion of this narrative is that the creditworthiness of mortgage holders is largely irrelevant because the mortgages are ultimately backed by the continued rise in the price of housing. This narrative eventually led NINJA mortgages where the house buyer had no-income, no-job and no-assets. Only the price of the house supported the repayment of the mortgage.
2. Waterfall Structure The diagram below shows the complex “waterfall structures” used in mortgage backed securities that supposedly protected investors from possible, but, according to the narrative, unlikely defaults on the mortgages included in the securities. Investors purchasing securities rated as AAA by the major rating agencies have been compared to people standing on the dry mountaintop while the people in the plains below suffered from floods. The waterfall structure is extremely complex. It is fair to say that the great majority of MBS buyers had a passing (if any) understanding of the details of this structure, relying instead on the narrative, presented by MBS sellers and the rating agencies, that the the AAA tranches of these securities offered U.S. Treasury like protection and a higher yield than other form of debt.
Dis-aggregating the Narrative
1. High Yield
By 2006 the spread between AAA rated subprime mortgage backed securities and U.S. treasuries had narrowed to well under 1%. In other words, the yield on mortgages was barely higher than yields earned by investing in the U.S. Treasuries, the most risk-free security on the market. The waterfall structure rested on the assumption that 1% protected the AAA mortgage holders which drastically under-priced risk.
2. Continued Rise of Housing Prices The chart below shows the increase in the price of houses leading up to the credit crisis of 2007-8. The steep rise in prices at the very least would give one pause to continue to assume that these prices could continue to rise, especially at the same rate. Yet, the entire subprime securities risk protection hinged on the continued rise in the price of houses to offset the deterioration in the credit quality of the mortgages and mortgage holders. This narrative that took a historical trend (the past rise in the price of houses) and projected it into the future.
The key elements of this narrative include “high yield,” “continued rise of housing prices,” “investor protection in case of defaults.” The Narrative Audit requires that each of these be examined to separate fact from narrative, appeal to logic rather than to emotion.
Dis-aggregating the narrative shows that several of its elements appeal to emotion rather than logic and impute a causality and forecast that is not warranted by the facts but can only be sold by the narrative’s appeal to faith and emotion. Similarly, the projected increase in the price of houses, which was the ultimate support for the entire structure, became increasingly myth-like over time, unmoored from supporting data.
This is not to say that conducting a Narrative Audit™ would have prevented all investors from acquiring MBS. However, it would certainly have caused the logical side of the brain to kick in and have a debate with the emotional side, perhaps leading the investor to forego this investment.