Subprime Lending: Truthiness & Delusion of Mind

After Citigroup collapsed late last year, I wondered whether the underestimation of risk in securitized investments was the result of a failure in using scientific methods of risk assessment. Read my post dated Dec. 5, 2007. Soon, I learned that such methods were widely employed in investment banking and insurance. Apparently, misconception prevailed about the reliability of the predictions that these methods provide.

A year on, we find out that the statistical software did not fail. Any scientific method will provide a realistic prognosis only, if the entered data are correct. We presume that a loan is approved with the assurance that the applicant is going to be able to service the payments through the loan period, provided that the applicant's financial situation does not change dramatically. This good practice seemed to have been widely ignored in the subprime and prime ARM (adjustable rate mortgage) loan market of the past eight years. Too often, applicant naivety and lender carelessness took sway over prudence.

In hindsight, the considerate risk analyst would have welcomed an additional column in the input spreadsheet with a truthiness factor weighting each loan. That is, the loan agent is asked to assign a score estimating the applicant's ability to service the loan once the interest rate resets. The agent could be rewarded for good judgment and the improvement in the quality of loans issued. Perhaps such estimates from the field would have helped to predict the risks with the ensuing securities more accurately.

In the absence of such information, the analyst is left to look at the foreclosures on the loans to examine risk retrospectively in the hope that forward projections gain accuracy. Paul Jackson reports on housingwire.com in a post dated Sep. 5, 2008, that the Mortgage Bankers Association (MBA) announced in early September that more than 9 percent of U.S. mortgages were delinquent or in foreclosure at the end of the second quarter of this year. “Subprime ARM loans accounted for 36 percent of all foreclosures started and prime ARMs, which include option ARMs, represented 23 percent,” Jackson quotes MBA's chief economist Brinkmann.

Addendum

• As The New York Times reports today, I am not far off with my assessment. Listen to this incredible story (11/5/08).