Psychology of Lending and The Dunning-Kruger Effect

Better Borrower Management

There is some basic psychology knowledge that all lenders must possess to help them excel on their job.  One field of psychology that lenders should understand is the Dunning-Kruger effect. The good news is that the Dunning-Kruger effect is not a disease, a syndrome or a mental illness. Psychologists David Dunning and Justin Kruger studied the cognitive bias of illusory superiority. The bad news is that most of us succumb to the effect and it largely explains why people mistakenly assess their cognitive ability as greater than it is. This often happens with borrowers when they plan and analyze their financing options. In this article, we will take a look at what the Dunning-Kruger effect does to borrowers and how to prevent it.

 

The Dunning-Kruger Effect In Borrowers

The cognitive bias of illusory superiority comes from the inability of a borrower to assess and prioritize input variable in choosing their lenders or asking for the right loan structures. Borrowers often don’t have the information or the experience to make an economically optimized choice which presents an opportunity for commercial bankers to add value. Understanding the Dunning-Kruger effect and tactfully helping borrowers avoid this bias can help lenders win more business and structure more mutually profitable loans.

 

Input Variables for Borrowers

There are many variables that borrowers consider when negotiating their loans, but in many cases, borrowers often focus on variables that make little economic difference. Borrowers focus on variables they cannot predict well and variables that have little impact on their long-term financial position. Lenders can help borrowers identify the correct variables to consider.  Because of the recent activity of the Federal Reserve, many borrowers are misjudging the importance of interest rates on their financing outcomes.  Many borrowers are attempting to forecast where interest rates are going and then structure their financing based on these inputs.  Unfortunately, borrowers are demonstrating a severe case of Dunning-Kruger effect.

 

Three Problems With Borrower Forecasting

Consider three important reasons why borrowers cannot predict and, ultimately, should care less about interest rate movement:

 

Lack of Predictability: First, there is no market consensus within the expert field.  Consider where experts forecast the ten-year (10Y) Treasury rate (the most widely forecasted rate in the industry).  We looked at 59 of the top bank and buy-side analyst predictions.  While the median forecast for the 10Y yield is 3.15% at the end of 2019, the low forecast is 2.20%, and the high is 3.90%.  The view of these 59 experts is broadly scattered.  While the range in the forecast for the 10Y Treasury yield is broad (1.70%), the same group of forecasters has a 2.00% range in Fed Fund rate at the end of 2019 (1.50% to 3.50%).  There is very little consensus among top prognosticators for either short-term or long interest rates.  However, as a side note, economists are rarely guilty of the Dunning-Kruger effect.  Economists place very low confidence number to their predicted numbers.  Why?  Because these economists have witnessed most of their predictions wildly off the mark year after year, and recognize their predictive defects.

 

Forecast Volatility: Second, the market is always in flux and changes its predictions, and sometimes very broadly.  Nowhere is this better demonstrated than the path of short-term rates.  The Federal Reserve was but certain to raise interest rates three to four times in 2019 until the market decided otherwise.  Below are two graphs showing the market’s expectation of short-term rates through 2019.  The graphs are a little busy with all of the branch outcomes. However, the direction and probabilities for each meeting are very telling.  The first graph shows the market’s view on November 1, 2018, and the second graph is the market’s view on January 11, 2019.  In less than two-and-one-half months the probability branches have shifted very broadly (75bps on the upside and 75bps on the downside).  The market will continue to change its prediction on interest rates, as it always does.  What is certain today, will be proven wrong in just a few months.

 

Fed Funds Future – Probability Path – November 1, 2018

Fed Fund Expectations

 

Fed Funds Future – Probability Path – January 11, 2019

 

Expected Fed Funds Future

 

Time Horizon Mismatch: The third and most important reason that borrowers should be circumspect in using interest rate predictions as input variables in structuring financing is the mismatch in time horizons.  The market and individuals are much better in predicting the path of interest rates in the short term.  As time horizons increase, predictive powers deteriorate.  In fact, the 59 economists cited above forecast out only six quarters.  The graphs above show Fed Funds futures only track market probability paths for 12 months.  It is very rare that borrowers finance projects for such short periods.  Borrowers need to plan for three to 30-years of financing.  Therefore, predicting interest rates for that period is foolhardy and, most importantly, a poor planning input for the borrower.  Even if a borrower can predict interest rates for the next year, that only covers a small portion of the financing duration.  

 

Application and Conclusion

When planning financing options, lenders need to focus borrower’s attention on input variables that the borrower can control and have a better ability to predict.  Instead of trying to foretell interest rates, lenders should direct borrowers to consider tax implications; hold periods; succession planning; sensitivity between net operating income and interest rate movement (not worrying about the absolute level of rates); and, optionality to future refinancing.  Relationship managers can become better-trusted advisors by structuring financing to reflect variables that borrowers can control instead of variables that are almost impossible to predict.