As capital flooded into the US debt markets in the wake of the Asian financial crisis--and I think that Asian savers and central banks bear much more of the responsibility for the credit bubble than can be plausibly pinned on either Alan Greenspan or Ben Bernanke--real interest rates also fell, which made housing an even better deal. The recency effect kicked in: as the bubble grew, it began to seem more, not less, likely that home prices would continue to rise. The bandwagon effect also reared its ugly head. Everyone else was buying a house on potentially catastrophic terms, so it must be safe!

Any self-introspection on the safety of the housing market was also plagued by bias. Examples of falling house prices were not available to memory; spectacular coups reaped by coworkers on a two bedroom fixer-upper were. And in testing their theory of future house prices, people looked for reasons that housing prices might rise--the many amenities of homeownership wherever they happened to live--rather than thinking of reasons that it might fall. Besides, the memory of the stock market crash was extremely recent and vivid. People began to see a home less as a place to live than an investment, a safe alternative to the risky securities market.

Once they had decided that it was likely to rise, they were overconfident in this assessment, which made them rather careless about the terms under which they signed mortgages.

Lenders went through much the same pattern. The revolution in credit scoring that took place in the 1990s actually did make lenders better at predicting default risk. As we moved into the current decade, however, the steady rise of home prices started to skew the numbers. Borrowers who historically might have defaulted simply sold their house into a rising market, recouping at least the value of their mortgage. Or they refinanced, getting much better terms because the loan now represented a smaller proportion of the overall value of the house, meaning that lenders were more likely to get all their money back.

As default rates fell, lenders went through the same process borrowers had. They too, overweighted recent events. They, too, looked at other people lending and concluded that it was probably safe. As I think I've mentioned before, several years ago, I had a conversation with an investment banker who did a lot of debt deals. As a general thought, he stated that we'd gotten much better at managing credit risk in the last ten years.

"Have we actually gotten better?" I asked. "Or do we just think we've gotten better."

"Oh no, we've really gotten better," he assured me. Oops.

Lenders built their risk models around pre-payment risk--the risk that buyers would refinance their mortgages, making your investment suddenly much less profitable. That had historically been the main risk of mortgage lending. As defaults stayed low, year after year, they revised down their expectations of default, viewing the current situation as a "new normal" rather than an unusually rosy time that might eventually regress to the mean. They tended to be overconfident about the probability that they were right and the boom would continue, making little provision for an eventual rise in defaults, much less what Nassim Taleb calls a "black swan" event, the kind of broad crisis that we see today. And they attributed the profits thus made to their own brilliance, rather than luck.