System 1 and 2 Thinking in Highly Stressful Situations

This week we are discussing a situation in which we used System 1 and System 2 thinking.

I’m going to reflect on the great recession in 2008-09 because that was a very emotional and scary time for many. I owned a small business and certainly have a great deal of stories to tell. There were so many decisions that I made that were disastrous, I could write a full thesis.

Our company was a waste management and recycling company. One of the large municipalities here in Long Island was issuing a bid for a municipal waste collection contract. It was a 10-year contract. Lowest bidder was the winner and no one company could service greater than 20% of the municipality, so there was going to be at least 5 winners. The bidding process started in mid-2007 and the awards were announced in early 2008. The contract gave us one year to prepare and the start date was the beginning of 2009. As all the hauling companies started bidding in 2007, we had no idea what was in store for the economy in 2008.

We were awarded our share of the contract along with 6 other companies (as I recollect). As we started to prepare for the contract, the economy started to fall apart. All the necessary capex needs for the contract had suddenly dried up. Specifically, there was no financing available for trucks and equipment (we were required to purchase new vehicles as part of the contract) and there were no insurance companies willing to step in an offer performance bonds or general insurance. It left us all scratching our heads on how to proceed. It was an issue that affected every company that had won the bid.

Panic started to set in.

Then our white knight arrived (or so we thought). T. Boone Pickens had come to town. T. Boone Pickens was a successful businessman that had deep roots in the energy sector, particularly natural gas. You see, the municipality had taken a green approach to the contract and required all the hauling companies to use compressed natural gas trucks to service the town. There was only one natural gas fueling station in the area and it was owned by one of Pickens companies. As I mentioned, he came to town and here is what he offered:

• The opportunity to hedge our natural gas cost at current prices over the life of the contract. • Trucking and equipment financing. • A line of credit to offer the township cash in lieu of performance bond (which was allowed as per the contract).

His representatives visited all the local haulers and told us this was an opportunity to prepare for the contract because the economy was on the brink of destruction. And to be very honest with you all, it felt that way.

System 1 thinking kicked into gear and this was an opportunity to solve all the problems related to this project and allow us to focus on the million other problems that were popping up every day. Seems like a no-brainer, right? Well here are the ugly facts about the arrangement.

The following is the price chart of NatGas as we were presented with the offer.

You can see that NatGas had appreciated +70% since we first bid on the contract. Not one company had thought of putting in hedges prior to the start of the contract (including us). So, we all had modeled the contract using fuel costs that were too conservative. Fuel is a major cost of the project and being locked in at these levels for the life of the contract was a serious issue.

The equipment financing that they offered carried nearly 12% interest charge (as I remember). That was about double the norm and what we all had modeled for. Another significant cost of servicing the contract. Their line of credit for cash in lieu of performance bonds also had a nearly 12% price tag on it. Performance bonds were modeled in using something closer to 3%. Another significant increase in costs. The contract did not require union labor, but there was a prevailing wage clause in it so there wasn’t much room to save on labor costs. The recyclables that we picked up (paper, plastic and glass) did have a value to them that we could sell, except the contract required us to take all recyclables to the directed Municipal Recycling Facility, so that was off the table. So, cutting costs meant equipment servicing and safety would most likely suffer. In the end, the deal required us to service this contract at reduced margins, quite possibly taking a loss on the contract over the 10-year period. PANIC! Shockingly every other hauler took the deal that Pickens had offered. We were the only company to turn it down. We didn’t know how it would turn out at the time. The good news is that NatGas dropped dramatically soon afterward (down to 4). Additionally, as the banking crisis really kicked into high gear (I’ll call it the Lehman collapse) and fiscal and monetary policy stimulus appeared. We were able to secure equipment financing that was more in line with historic norms. We eventually got the proper insurance and bonding in place (with a little leniency from the town) and we were off to the races with the highest margins in town. Some observations from the experience. Kahneman (2003) states “uncertainty is poorly represented in intuition, as well as in perception. (p 701)” When the economy seemed to be falling apart, it was something we have not seen in our lifetimes. While this wasn’t a life-threatening situation, it was a life-altering one and the uncertainty was frightening.

What is surprising to me was the shelf life of System 1 thinking. This wasn’t a decision that had to be made within minutes. We had several weeks to mull it over and yet all the other haulers took the deal. Given the amble time – System 2 thinking should have had an opportunity to override System 1 thinking to come to a better solution. I suppose in this instance, the haulers must have assumed the Pickens deal was the only option available (which it wasn’t) and went with it. System 1 had failed to make the correct decision and System 2 failed to counter System 1. So, there was a complete breakdown within both systems, at least according to my interpretation. In our readings we find that the corrective operations are impaired by time pressure, concurrent involvement in a different cognitive task, and mood (Kahneman, 2003, p.711). Perhaps these were variables that led to the decision.

According to Kahneman (2003, p 717), “The model suggests five ways in which a judgement or choice may be made:

1. An intuitive judgement or intention is initiated, and • Endorsed by System 2; • Adjusted (insufficiently) for other features that are recognized as relevant; • Corrected (sometimes overcorrected) for an explicitly recognized bias; or • Identified as violating a subjectively valid rule and blocked from overt expression.

2. No intuitive response comes to mind, and the judgement is computed by System 2.”

I think perhaps the decision-making process related to Pickens offer falls into the second category.

I also believe there were two overriding factors that influenced the decision. The first was the Endowment Effect. These contracts were highly coveted by the waste haulers after a highly competitive bid and the possession of the contract may have skewed the decision-making process. There was potentially

Recency bias involved. Given the current state of the economy, the decision-makers were recalling the most recent events unfolding without the thought that things would eventually get better.

Given these behavioral influences the options that were not considered include:

1 – Not taking the Pickens deal with an understanding that better options may become available 2 – choosing to opt-out of the contract entirely (which would have resulted in a loss of thousands vs. potentially losing millions in an unprofitable 10-year contract).

Joseph S. Kalinowski, CFA

Kahneman, D. (2003). A perspective on judgment and choice: Mapping bounded rationality. American Psychologist 58(9), 697-720.