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Paragraphs to ponder
The pursuit of “risk sensitivity” led to a re-organisation of bank assets away from lending on the basis of the banker’s private views about the borrower - regulators considered this hard to quantify and a little suspect – towards lending on the basis of an external credit rating. The higher the rating, the lower the capital banks had to set aside against the loan. Regulators saw this as not only risk-sensitive but transparent and quantifiable. Banking by numbers was oh so modern.
Here is much more, interesting throughout.
Posted by Tyler Cowen on October 8, 2008 at 07:24 AM in Economics | Permalink
Comments
Isn't this an argument against globalization (expansionism in general) and for localism?
I've offered this statement up before - and I'm not sure if most here are coming at this from some tacitly agreed upon party line - but it seems almost universally rejected: perhaps risk-taking in general isn't something to be lauded.
Risk taking in certain endeavors, sure, but in core industries (e.g. banking) it's probably not such a great idea.
And you probably ought not be encouraging it.
Posted by: meter at Oct 8, 2008 9:07:44 AM
So, in essence, they decided the solution to pollution was dilution by shuffling a few bad loans in with the good ones?
The problem is when you think you have 1% contamination, it doesn't take a big absolute number change to have a big effect on the percent change of contamination. Then add to the mix that you don't really know because the flavor was masked by the ratings, spice things up with leverage and that your capital requirements are based partly on market values for these packages and voila...who wants to be the taste tester! We promise there is just a small amount of crap in the sandwich!
Posted by: Andrew at Oct 8, 2008 9:08:48 AM
Meter,
Risk taking should be encouraged (by the natural rewards). People are too conservative by nature.
The problem is taking risks when you think you are being conservative because you are relying on ratings, diversification, quants and herd mentality to protect you. When the whole herd goes off the cliff, safety in numbers doesn't save you.
It's no party line, here. I just don't understand why people are so worried about 'saving' a banking system that so obviously sucks. I mean, it's the only system we have, but it's just not that great. The real economy is still stumbling along despite this rattle-trap finance system. Now, what party would endorse THAT line?
Posted by: Andrew at Oct 8, 2008 9:14:39 AM
Is it really possible to return to a bygone era? Subjective evaluation of an applicant's character is an invitation to a discrimination lawsuit. The unseen hand nowadays is litigation.
Posted by: anonymous at Oct 8, 2008 9:17:36 AM
"Risk taking should be encouraged (by the natural rewards). People are too conservative by nature."
This is what I refer to: you say that as if it's some natural law. By what metric are people "too conservative?"
I don't know how you can say that when, for example, in this country we have negative savings rates. Or, say, as we stand on the precipice of the most spectacular financial meltdown in the history of this country (if you are to believe Paulson & Co.).
Maybe relative stability is more important than chasing after that extra 5%.
Posted by: meter at Oct 8, 2008 9:29:54 AM
To me, the best evidence is the fact that these people were investing in things that they thought were risk-free and now that there's just a little more risk than they thought they are scared witless. The ones who had 40-to-1 leverage, that's just dumb, I don't call that risk-taking, I call it suicide, and they are dead, mostly. The ones who aren't I think will be soon enough. High leverage is a tacit admission that you can't create real value, just my opinion.
The fact that we get "too interconnected to fail" is a separate problem. People thought they were insured against this, they weren't. I'm almost wondering if they didn't even want to look because they were scared of what they'd find.
Savings rates are not completely reflective of actual saving and no, I don't believe Paulson. Old people have tons of assets. People in other countries keep sending their money to us rather than investing in their own countries. Speaking generally, people keep buying bonds to the point that they bid down the prices so that they vastly underperform. They buy CDs and annuities(!). They are buying treasuries just to get their principal back. They are shocked when stocks have a couple down quarters. Research shows that people psychologically hate a loss of $1 more than they like a gain of $2, or something like that.
I could probably go on. But, I'm used to looking at the exact same evidence as others and arriving at the opposite conclusion :)
Posted by: Andrew at Oct 8, 2008 9:47:24 AM
Meter,
Maybe a better way to phrase my view would be that people are too enamored of the status quo, I'll have to ponder that.
Posted by: Andrew at Oct 8, 2008 9:51:07 AM
People are risk averse but often they do not understand that what they are doing is risky. The people that I see taking risks see no risk in their behavior, to them it is a sure thing. On the other hand con men can use people's risk aversion against people, E.g. the organic food industry. Con man Kevin Trudeau has a nutritional book that uses fear of toxin in food to sell the book. People risk wasting money and time on his book and its prescriptions for fear of the risks of pesticides which have over and over again been proven safe.
Posted by: floccina at Oct 8, 2008 10:05:16 AM
Regarding lending based on privately held view: My family is from a small Southern town which used to have 1 local bank. In the 70's, my parents went to borrow to buy a Honda. The bank president said no because he didn't want to lend for a Honda. My grandparents had gone to the bank in the 60's to borrow to by furniture, and he wanted to know what type and from where first. Another family went to take out a home equity line of credit to build a swimming pool. He said no because he didn't think they needed one. Any system will work great if the people running it are saints.
Posted by: Micael at Oct 8, 2008 10:45:53 AM
Bernanke: "Inflation outlook has improved somewhat"
Now this guy REALLY has a subtle sense of humor.
Posted by: Andrew at Oct 8, 2008 10:56:55 AM
This seems very borrower-focused. Isn't the relevant hard-to-quantify judgement not "the subjective evaluation of this borrower" but rather "a subjective evaluation of whether we are in a bubble?"
If housing prices decline by 10% a subprime borrower is at risk of default. That seems like a very quantitative problem with subprime mortgages to me, which has nothing to do with the trustworthiness of the borrower.
Now, Andrew Kling has suggested a related point: lenders started "learning" that credit score was the most predictive metric of risk, but they learned it within a very peculiar environment (a bubble). But this isn't too much quantitative reasoning, it's stupid quantitative reasoning. You can't extrapolate from a bubble what will happen in a non-bubble.
Posted by: mk at Oct 8, 2008 11:52:15 AM
Revising this a little bit: Credit rating appears to not take into account the borrower's income (is that right?). That means that we have all these complicated sliced-and-diced mortgage medleys, but we can't easily look into them to see whether the borrowers have the income to weather the decline in housing prices. Thus, the risk of default on every mortgage is hard to measure.
Is that right? At first blush then, it seems like if we'd passed along more quantitative information (like income information), we might be better able to perform on-the-spot assessments of the risk profile of a mortgage medley.
On the other hand, if Joe Debtor loses his job are you really going to find all the relevant CDO's and update those with his new income? Probably not. Which seems to indicate that it is truly impossible to pass along a single number (or group of numbers) that give a precise time-independent view of the risk of default.
I have no idea if the above paragraphs are total nonsense ;)
Posted by: mk at Oct 8, 2008 12:38:20 PM
Income levels aren't part of credit scores, and they probably shouldn't be. (I know low-income people who take debts very seriously, and some rather rich people who refuse to pay their bills unless they are sued. Probably why they are rich.)
But they should definitely be part of the mortgage information. Although lenders may have been over-relying on credit scores, and incomes may have been falsified, I would be moderately surprised to find out that the income level was just missing.
Posted by: Dan Weber at Oct 8, 2008 1:14:56 PM
Andrew wrote "The ones who had 40-to-1 leverage, that's just dumb, I don't call that risk-taking, I call it suicide..."
Hubris is another good word: "overbearing pride or presumption"
mk wrote "this isn't too much quantitative reasoning, it's stupid quantitative reasoning. You can't extrapolate from a bubble what will happen in a non-bubble."
This is a very basic problem in applied statistical practice -- overgeneralizing from a limited context.
Similarly, basic notions of covariance seem to have been given short shrift. If mortgage#1 defaults 1% of the time and mortgage#2 defaults 1% of the time, the probability of them both defaulting isn't the independent calculation .01 * .01 = .01%, but a number considerably closer to 1% considering it's known that economic cycles affect default/foreclosure rates.
Posted by: zbicyclist at Oct 8, 2008 2:25:23 PM
Just some thought:
Risk of default is variable and dependent on many factors, some of which are "risky" in themselves (e.g., health and divorce). Then, if the loan is for 30 years you need to predict whether a default will occur over the lifetime of the loan.
My gut says that people are generally have positive risk-affinity since the downside, for many, is floored. The CEOs may fail to get money but they rarely lose any no matter how poorly they do. The average Joe, and his 401(k), have the government to protect them. Whether or not we "encourage" risk taking and profit-mongering I would suggest that they will occur anyways since those holding power are pre-disposed to that kind of behavior.
"If housing prices decline by 10% a subprime borrower is at risk of default." - this may be the reality (if you assume 7/1 ARM, 80/20 piggy-back loans for sub-prime borrowers) but I would suggest that both effects are incidental of each other; though sharing similar causes.
Extending the linked piece, it seems that the ratings system has been hijacked. Instead of rating a company and its ability to make good on its bonds the models are being bent to not only rate the first-tier borrower (the mortgagee) but ALSO the second-tier packager (the mortgagor).
Also, from the piece: "One of the implications of this risk sensitivity is that bankers were given incentives to enhance the credit rating of lending to reduce their capital charges and improve their profitability."
I am getting confused as to whom he is referring since in these cases the packager is getting the cash and doesn't need to setup reserves - regardless of the rating those packages get (right?). Maybe its a matter that the reserve requirements information is lost when the repackaging is performed. If I package an "AAA" and a "BB" together I only need to hold reserves as if I had an "A" as opposed to "AAA" + "BB" (average vis-a-vis sum). I guess the comment about covariance falls in here since it they are independent then an average is more reasonable whereas with dependence a sum is necessary.
In all I agree with the article's premises and, to phrase it my own way, the models used did not include any subjective inputs nor were the models used in support of a subjective process of approval/denial. If only single mortgages were done this way, however, there really wouldn't be that large of a problem or the uncertainty in how to go about patching things up. It is because the re-packaging models were designed/used this way that the problem has gotten to where we are today.
Posted by: David J at Oct 8, 2008 4:17:48 PM
Think Hayek, "The Use of Knowledge in Society." What can inform better about the credit worthiness of an individual: Local knowledge or centralized algorithms? What are the costs of applying each? What are the benefits of doing one rather then the other (increasing reliability of one's estimate)in regards to an individual loan or lender?
Posted by: Rob Nelson at Oct 10, 2008 1:55:16 AM
