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.

Addenda

• As The New York Times reports today, I am not far off with my assessment. Listen to this incredible story broadcast on National Public Radio's Morning Edition. What were the banks thinking (11/05/08)?
• Today, Lynn Adler reports on Reuters that according to a recent Mortgage Bankers Association assessment roughly 13 percent of U.S. households were three months late with mortgage payments or in foreclosure at the end of 2008 (03/05/09).
• As Michael Osinski, one-time author of bundling and valuation software for mortgages, suggests in this segment broadcast today on National Public Radio's All Things Considered, his programs would have benefited greatly from an entry for the probability with which a borrower was actually able to realize the estimated value of the real estate borrowed against (04/05/09).
• The current financial crisis began with an extravagant real estate boom that nobody could afford and will end, once the last foreclosed properties are sold. Read David Leonhardt's report in The New York Times, published yesterday.  I reckon that we shall reach the turning point no sooner than 2011 (04/22/09).
• Lynn Adler reports in a post on Reuters today that foreclosures have by far not peaked out yet according to an analysis by RealtyTrac.com (05/13/09).
• If you like to find out how many years it will take to recover a loss in home value, you may wish to use the calculator here (05/21/09).
• According to Nouriel Roubini's assessment of the economic outlook in an interview with Reuters yesterday, my prediction of recovery perhaps in 2011 may not be far off the mark (06/17/09). Watch below:
  
  
  
• According to Ilaina Jonas' analysis on Reuters today, commercial mortgage holders are also finding it increasingly more difficult to refinance. About 4.5 percent of commercial loans are a month or more in delinquency, compared with 1.2 percent in 2007. Commercial real estate has lost a third in value since. Many borrowers cannot obtain the funding they need. In contrast to residential mortgages, however, lenders are more willing to extend these loans in the hope that the borrowers will regain sufficient liquidity soon (07/23/09).
• In her post on Reuters today, Lynn Adler reports that according to the latest assessment of RealtyTrac foreclosures reached a new peak with 360,000 filings nationwide in July. Further increases are expected in coming months, when state legislature-instituted moratoria expire. The recession may have bottomed out. But, recovery has not yet begun (08/13/09).
• According to The Economist's daily chart post dated Aug. 21, 2009, one in four home sales at present results from repossession (08/29/09).
  
• Among the bank CEOs who have been testifying before Congress to illuminate the causes of the finnacial crisis, the mortgage brokers seem the most defiant and delusional, denying any failure of risk assessment in their actions during the housing bubble. National Public Radio's news staff published an informative article with the title "Ex-Washington Mutual CEO Criticizes Bank's Seizure" on today's testimony of former Washington Mutual CEO Kerry Killinger before Congress. The text of Killinger's testimony can be downloaded on the Wall Street Journal's site. You may wish to listen to the podcast with his pronouncements entitled "WAMU CEO Defends Bank at Senate Hearing" on Nation Public Radio's All Things Considered (04/13/10).
• According to Gretchen Morgensons report with the title "How Countrywide Covered the Cracks" published online in The New York Times yesterday, the head of Countrywide Financial Corp. and co-founder of the company Angelo R. Mozilo anticipated in 2005 that the company's aggressive promotion of adjustable-rate mortgages (A.R.M.s), particularly subprime mortgages and pay-option A.R.M.s, would spell disaster, when the housing market slowed and the interest rates reset. Pay-options allowed the borrowers to pay less than the stipulated monthly installments, while their payments were applied only to the interest and the unpaid remainder was added to the mortgage, substantially increasing the mortgaged amount. Already in 2004, adjustable-rate mortgages comprised roughly half of Countrywide's loans and pay-option A.R.M. a quarter. Mr. Mozilo warned of the risk these loans posed to the company in internal communications, but portrayed an upbeat and overtly optimistic picture on the outside. He was also concerned about loans that allowed borrowers to purchase homes without down payments. Despite, his company continued to push these products unrelentingly. Countrywide was sold at bargain price to Bank of America in 2008. Because he continuously had sold his stocks in the company up to that point, without sharing his concerns with investors, he agreed last week in a settlement with the Securities and Exchange Commission to pay 67.5 million dollars as penalty and reparations to investors (10/17/10).
• Jason Zweig posted an informative article entitled "The Man Who Called the Financial Crisis-70 Years Early" with The Wall Street Journal today. The article tells the story of the Hungarian economist Melchior Palyi (1892-1970) who foresaw in the 1930s that many measures the U.S. government implemented to stabilize the economy after Black Tuesday, 1929, would lead to another financial crisis fueled by wide-spread defaults on mortgages (11/06/10).
• After a month-long hiatus, Bank of America resumes foreclosures on 16,000 residential properties (12/10/10):
  
• According to Corbett Daly's report with the title "U.S. single-family home prices fell for a fifth straight month in November and could plumb new lows soon, a closely watched survey showed on Tuesday" posted online on Reuters today, the seasonally-adjusted Standard & Poor's/Case-Shiller composite index of home prices in 20 metropolitan areas fell 0.5 percent in November from October. The finding suggests that the housing market has yet to recover and we may be headed for a second dip before Spring (01/25/11).
• I was hoping that the housing crisis would be over by now. But robo-signing, bungles in bank record keeping and the ensuing law suits slowed foreclosures down, impeding recovery of the housing market. In this interview with The Wall Street Journal published yesterday, Nouriel Roubini provides informative insights on the current economic outlook (08/12/2011):