Subprime with a Ski Chalet: The Triumph of Data Over Common Sense

One of my favorite parts of the Loewenstein article on subprime I mentioned yesterday was this account of how a ratings agency rationalized its approval of a risky group of mortgages:

[In the package of loans,] Moody’s learned that [over 38 percent of the borrowers] did not provide written verification of their incomes. . . . On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” [one analyst] said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”

In this outstanding story on This American Life called “The Giant Pool of Money,” we learn more about how these rationalizations worked. CDO-mongers using “analytic software designed by Ivy League graduates” found that “the data on loans that were [a few] years old were positive. They performed very well. . . . [For example, a] 90% no [verified] income loan from 3 years ago is performing amazingly well. Instead of defaulting 1.5% of the time it defaults 3.5% of the time.” One of the reporters calls this a “triumph of data over common sense,” since it should have been obvious to anyone that the historical data was irrelevant to a transmogrified mortgage industry. As Loewenstein’s article put it,

Moody’s used statistical models to assess C.D.O.’s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.’s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, “There was a large failure of common sense” by rating agencies and also by banks like his. “Very complex securities shouldn’t have been rated as if they were easy-to-value bonds.”

But when does a “failure of common sense” become recklessness, fraud, or something worse? In 2007, “278 subprime-related lawsuits were filed in federal courts.” The more one listens to stories like TAL’s, the more likely an avalanche of litigation appears.

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