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):
  
  
  

The Days the Worst Things Happen

Real bad news always strike us in surprise. 
Whatever defenses we devise,
we are standing unwarily, 
making coffee, 
making tea.

The program is interrupted unexpectedly.
 A special announcement is read.

Shots rang out and killed the President!

Airplanes rip into towers.
Thousands are trapped!

Sixteen minutes to landfall,
the spaceship is breaking up!

People are in pieces.
We are standing numb.

We forget about the coffee, tea.
We are transfixed to the radio, TV.
Good people lost lives, loved ones, 
friends, family!

The morning is crisp and bright.
The birds are chirping. 
Things look all right.

Yet, we sense something has changed.
Something has happened far away,
something no good,
and we will always remember
what we did that day.

Kurosawa's Teachings on Leadership & Academe

Today we commemorate the achievements of the great Japanese film director Akira Kurosawa on the tenth anniversary of his passing. Kurosawa made countless contributions to the understanding of human behavior. He provided us with one of the most impressive descriptions of the changing relationship between humans and nature with his narrative on the life of the hunter Dersu Uzalain the vastness of Siberia around the turn of the last century. In Rashomon,he tells us about the treacherous mission of a judge attempting to establish the truth in a criminal case. The search ends in the admission that objective actuality cannot be established from subjective experience, arguing profoundly for the use of the scientific method in our lives. Kurosawa's most striking contributions touch on human leadership. In one of his short films collected in Dreams,a retired officer recounts his life-long nightmare of having sent his soldiers on a mission, from which none returned. The film paints in graphic, indelible strokes the pains of war and the horrid memories that torment the man decades after the experience. It argues strongly that for their own sanity officers must go first, leading their troops into action. In Seven Samurai,Kurosawa portrays the ambiguous relationship between citizenry and military. In times of war, we love our military. In times of peace, we feel no need for it. Leadership and power pervade Kurosawa's brilliant adaptations of Shakespear's plays, transposing them into the Japan of the Shoguns and Samurai (Ran).

The master tells about the challenges of leadership most strikingly in Kagemusha.A great warlord is mortally wounded in a siege. In order to ensure the success of the campaign, his advisers decide to search for a substitute. They find the ideal candidate in the person of a beggar sentenced to die for a small crime. In exchange for his life, the man pledges to play the lord's role until the campaign is over. He resembles the deceased noble so much that even the wives and concubines mistake him. The advisers teach him the manners of life at court. The man learns his lessons and gradually adopts his new role as the lord. However, at all times he is plagued by the anxiety about wrongfully assuming the role of some one above his station. Moreover, his fear lingers that the nobles will kill him, once they do not need him anymore. But he plays his role well, so well in fact that he assumes true leadership in the most decisive moment on the battlefield.

After his formidable performance, the exhilarated advisers ask him to stay on. He declines. His ingrained sense of status forbids it. He feels that lordship is not a beggar's station. Plus, he was just a stand in, a deception. With regret, the nobles set him free. They toss him out on a country road where he resumes his old life of an impoverished vagrant. But his innocence is lost. He remains eternally tormented, witnessing that without his leadership the kingdom succombs to the onslaught of its adversaries.

This great tale offers many lessons for modern leadership. For example, academe today is still governed with a strong sense hierarchy. Young talent is hired on the promise of success and tenured once the promise is fulfilled. In U.S. research universities, the success is pegged to the amount of research dollars garnered from Federal agencies. These agencies add about 50 % indirect cost for overhead expenditures on every dollar they pay out in direct costs for the research. Only a bit more than a tenth of the research proposals is funded. However, assuming a rate of 50 % overhead American universities recover roughly $8 billion in indirect cost from grants awarded by the National Institutes of Health alone in fiscal year 2008. Without this sizable allotment, many institutions could not sustain themselves. Therefore, the pressure on the faculty to obtain federal funding is exorbitant. Established funding histories become necessary prerequisites for tenure and further promotion. This struggle consumes many a talented scientist, turning beggars into warlords they should not be, in analogy to Kurosawa's tale.

Often the energy is spent, once tenure is obtained. Creativity is drained. Productivity ceases. Soon funding evaporates. It becomes harder and harder to make a scientific contribution or even to keep up appearances. At that stage, universities have not developed adequate and effective mechanisms to realign faculty salary with performance. Offers for early retirement may leave a decade of limbo which neither the concerned faculty nor the university knows how to fill meaningfully. Administrative promotion may not provide a solution. Too easily, the Peter Principle applies. That is, faculty members are promoted to functions with ever greater expectations and fail. Since the academic promotion system is unidirectional, a sizable fraction of the hard-won Federal funding is bound to be spent on high salaries with little to show for. Frustration mounts among the involved parties, and the mind that is supposed to be preoccupied with finding the solutions for tomorrow's problems is increasingly consumed with the struggle for meaning and place in a combative environment. At this juncture, it is wholesome to reflect on one's original goals in life and on a timely strategy to negotiate a dignified and respectful path back to these goals.

In Kurosawa's tale, the beggars' decision to return to his former life was of defining importance not only for his own fate, but also for the fate of his country. The audience is left with the sense that he should have stayed on the job. His belief in predestination and his truthfulness prevented him from doing so. In our society unbound by destined fate, thorough reflection and careful planning should help us to develop and offer favorable individualized solutions, facilitating the proper choice at the opportune moment.

Addendum

• Today, National Public Radio's All Things Considered reported in a segment by Iris Mann entitled "A Kurosawa Celebration, From Many Angles" about Akira Kurosawa's achievements on the occasion of the restoration of Rashomon (11/10/08).

Limits of Brain & Mind

While I was pedaling across a beautiful college campus the other day, the above inscription caught my eye. It adorns a magnificently restored building. The statement gave me pause. I am a anatomist. The human brain weighs roughly 1,350 g and fits snug into a half-gallon pale. I looked down into my bicycle helmet. The brain does not take much room. Yet, this clump of nondescript soft tissue allows us to produce statements that bold.

The interactions between the nerve cells in the brain define who we are. Networks of nerve cells control our behavior and permit us to muse about the world around us, ponder the limits of the sky and make dreams come true. We are even able to comprehend happenings in places too distant for us to travel. We can imagine the universe. Our mind is indeed wider than the sky.

Alas, the brain is vulnerable, the mind is fragile. Injury to the brain alters the mind. Both are inseparably complementary. Rhymes formed up in my mind. I put them down in a poem with magic ink. Take six minutes and watch the words unfold in the viewer below.

Addendum

• "The brain is wider than the sky..." is the opening to a poem by Emily Dickinson who lived in the 19^th century. She was no neuro-anatomist. Her poem is more beautiful than mine.