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Asking More Commentary: Perspectives from Mendoza College of Business

Commentary Post - Ed Conlon

What Causes the Biggest Bad Decisions

August 2, 2010

This article was published originally on  Editor.

The Challenger disaster has become standard at business schools for showing how big and important decisions in organizations can go terribly wrong. The major lesson from it is that even when decision processes are carefully planned and mapped out, a combination of business interests and uncertainty can conspire against making the right choice.

The Challenger launch probably wouldn't have taken place had NASA followed the prescribed decision process it had used for every other manned space flight. On the morning of Jan. 28, 1986, the temperature at the launch site was in the low 30s, much colder than for previous launches. The cold threatened the effectiveness of critical seals designed to prevent the main rocket engines from igniting and exploding the attached fuel tank.

However there were special and compelling interests present. And along with a high degree of uncertainty, those interests conspired to push key decision makers to accept risks they would have otherwise avoided. Specifically, the engineering team at Morton Thiokol, the company that had designed and manufactured the rocket engine, recommended against launching at such a low temperature. They felt there was a significant chance the rubber seals would be too hard and therefore not function properly. Usually this no-go recommendation would have stopped the launch sequence.

But then business and political forces exerted themselves. For Morton Thiokol, there was the prospect of damaging its relationship with NASA if it called off the launch. For NASA there was congressional pressure to perform. And the White House had plans to showcase Christa McAuliffe, about to become the first teacher in space, during the upcoming State of the Union address. Although science supported the engineers' recommendation not to launch, there wasn't enough data about low-temperature launches to prove that the seals would fail. Consequently the no-go recommendation was reversed, and the countdown continued. Challenger spectacularly disintegrated 73 seconds after launch.

We are currently witnessing the consequences of two other decision failures that are eerily similar to the Challenger one. Both the subprime mortgage crisis and the Deepwater Horizon tragedy share the common elements of having compelling and aligned interests among their decision makers and the uncertainty that is inherent in novel circumstances. In both cases, those elements combined to lead to disaster.

In the case of the subprime mortgage crisis, the interests involved were threefold: a well-intentioned national policy of increasing the number of Americans owning homes; the opportunity created for investors to earn attractive returns by funding residential mortgages for those new homeowners; and the opportunity for financial businesses to create and market the mortgages to prospective homeowners and to package and sell the cash flow they created as investments.

Altogether these interests created a surge of activity selling new kinds of mortgages to new kinds of homeowners and packaging the mortgages as new kinds of investment vehicles. They also created a regulatory environment that wanted to support national policy as far as seemed reasonable.

Uncertainly and ambiguity arose with the creation of new more relaxed qualification standards for residential mortgage loans, new kinds of complex investment instruments (including collateralized debt obligations) designed to raise the capital needed to support the residential mortgage loans, new kinds of insurance policies on investments (credit default swaps) designed to mitigate the risks for investors, challenging levels of complexity for the agencies that rated the investment vehicles and an assumption that the collateral value of residential real estate in America would remain strong enough to limit potential losses.

For a time it all worked. The new financial engine succeeded in creating a whole new class of American homeowners, happy mortgage brokers, happy investors and happy bankers. Home ownership reached nearly 70% in 2004. Home prices jumped nationally at nearly 9% a year from 2000 to 2006. A home worth $150,000 in 2000 was worth $251,565 in 2006.

By the summer of 2007, though, the picture began to crack. Several mortgage lenders filed for bankruptcy, and financial firms began to suffer heavy losses on subprime securities. When mortgage holders began to default in large numbers, and the value of the collateral began to drop, the subprime mortgage market failed. The securities backed by defaulting mortgages became worthless. The overall size of the failure, in the tens of billions, was sufficient to threaten the entire financial system and the world economy.

In the case of the Deepwater Horizon explosion, the interests that came to bear included a national policy of reducing dependence on foreign oil by more fully exploiting domestic sources. That led to special incentives and new profit opportunities for all companies involved in deep-water oil exploration (anything deeper than 1,000 feet), including BP, Transocean and Halliburton.

Thus there was a burst of well drilling in deep water that had previously been regarded as not economically viable, and a regulatory environment emerged that generally supported the development of those new deep-water resources. Yet drilling and establishing wells in very deep water involved working in an environment seldom encountered before. Little was known about dealing with accidents or failures in deep water--about, for instance, regaining control of a deep-water well following an explosion and fire on the drilling platform.

In the rush to develop new sources, questionable assumptions were made, risks were taken, concerns were overlooked or ignored and, ultimately, a worst-case scenario came true. BP could spend more than $40 billion on cleanup and liabilities, but even that amount of money wouldn't address the collective suffering of people, whole communities and wildlife.

Must disasters of this sort continue to occur?

Certainly not, but important changes will need to be made in how such big decisions are approached and reviewed.

First and foremost, we need our decision makers to recognize a problem when they encounter it. Aligned interests create a shared bias toward action, a universal desire to move ahead with strategies and tactics that serve those interests. Morton-Thiokol and NASA both badly wanted to launch the Challenger a soon as possible. The government, the banks and investors all wanted additional mortgage loans to be made. The government and the petroleum industry shared a strong interest in exploiting rich known sources of domestic oil and gas. Whenever interests are that well aligned behind a course of action, greater diligence is needed to make sure that the full range of risks and consequences of failure are well understood and fully appreciated. We need to ask how wrong we will need to be before we change our preference for action.

Second, these three situations I also had in common being new and untried. NASA had never launched a shuttle when the temperature was below 50 degrees. Wall Street was relatively unfamiliar with assessing the risk of securities backed by residential mortgages to individuals. Industry had little experience drilling wells at extreme depths or dealing with catastrophic failures at those depths, temperatures and pressures. These are precisely the kinds of situations where caution should win, not expedience, and where the voices of technical experts deserve the greatest attention, especially when they are contrarian. In all three cases, those voices don't seem to have gotten much attention.

Finally, there is an enormous responsibility at the top to ask the right questions and insist on thoughtful and honest answers. The leaders of businesses whose everyday actions can save or kill astronauts, enhance or destroy entire economies, preserve or destroy hundreds of miles of coastlines and oceans or produce any number of other catastrophic outcomes bear a special burden of carefully assessing the upside and downside of their actions not only for shareholders but for the wide range of stakeholders. They are rightfully subject to a very high standard of care and reasoning.