Monday, July 7, 2008

How Models Caused the Credit Crisis

(Felix Salmon) Ryan Chittum asks if we want to know what caused the global credit crisis, and suggests that if we do, we should "start here", with a 22-page report about subprime lender IndyMac from the Center for Responsible Lending and former WSJ reporter Mike Hudson.

The report certainly manages to be both shocking and depressing at the same time. But by this point it's well known that subprime lenders often behaved in an irresponsible and predatory fashion. What's more, that behavior wasn't a cause of the global credit crisis, so much as a symptom of it.

As Wolfgang Münchau says in today's FT:

If this had been a mere financial crisis, it would be over by now. The fact that we are suffering its fourth wave tells us there might be something at work other than merely financial euphoria and bad regulation.

This is true, even if you don't buy Münchau's assertion that the real cause of the crisis was New Keynesianism and the dynamic stochastic general equilibrium model in particular. I would rather place the blame at the acceptance of models in general. Gillian Tett explains:

This decade, financiers have invented so many brilliantly clever mathematical tools to repackage risk that the industry has slipped, almost unthinkingly, into an assumption that "credit" is a collection of abstract equations, stripped from any human context.
Thus banks have become so dazzled with their powers that they have ignored how they interact with the rest of society - or how the tribal aspects of their own institutions can create dangerous traps.
Meanwhile, the cult of models has become so extreme that banks have believed them even when this collides with common sense. Yet, as any Latin scholar knows, the word "credit" hails from credere: "to trust". It is, in other words, also a social construct.
And bankers forget this human dimension to their cost.

Sam Jones has one striking visual of that cost: a bar chart showing the current ratings of 469 CDO tranches which were rated AAA at issue. Fewer than a quarter of them retain that top rating; a lot of them are now CCC rated, and a fair few even have a D rating.

The reason that IndyMac was writing so many horribly bad mortgages was that there was no shortage of investors willing to trust models telling them that the bonds secured by those mortgages were incredibly safe. They didn't need to look at the mortgages themselves, since they had bankers using models to do that for them.

In other words, IndyMac's behavior was certainly irresponsible, probably illegal, and also entirely predictable. Could we have known that IndyMac specifically would extend a loan against a stated Social Security income of $3,825 a month, even when the maximum Social Security income at the time was barely half that? No. But inevitably someone would, just because of the ease with which lenders were able to sell all their downside at a substantial profit.

Hudson concludes his report by calling for "rigorous oversight" of lenders, and "rules that will prevent such disasters from happening again". But that's only half the solution. The real art is to try very hard to design a financial architecture where rules and incentives work with each other, rather than in opposition to each other. Because when there are billions of dollars to be made by breaking the rules, you can be sure that the rules will end up being broken.

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