Subprime with a Ski Chalet: The Triumph of Data Over Common Sense
posted by Frank Pasquale
One of my favorite parts of the Loewenstein article on subprime I mentioned yesterday was this account of how a ratings agency rationalized its approval of a risky group of mortgages:
[In the package of loans,] Moody’s learned that [over 38 percent of the borrowers] did not provide written verification of their incomes. . . . On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” [one analyst] said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”
In this outstanding story on This American Life called “The Giant Pool of Money,” we learn more about how these rationalizations worked. CDO-mongers using “analytic software designed by Ivy League graduates” found that “the data on loans that were [a few] years old were positive. They performed very well. . . . [For example, a] 90% no [verified] income loan from 3 years ago is performing amazingly well. Instead of defaulting 1.5% of the time it defaults 3.5% of the time.” One of the reporters calls this a “triumph of data over common sense,” since it should have been obvious to anyone that the historical data was irrelevant to a transmogrified mortgage industry. As Loewenstein’s article put it,
Moody’s used statistical models to assess C.D.O.’s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.’s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, “There was a large failure of common sense” by rating agencies and also by banks like his. “Very complex securities shouldn’t have been rated as if they were easy-to-value bonds.”
But when does a “failure of common sense” become recklessness, fraud, or something worse? In 2007, “278 subprime-related lawsuits were filed in federal courts.” The more one listens to stories like TAL’s, the more likely an avalanche of litigation appears.
May 14, 2008 at 9:06 am
Posted in: Corporate Law, Economic Analysis of Law
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Responses (1)
James Grimmelmann - May 14, 2008 at 10:08 am
There’s another explanation for the failure of the rating agencies, one that doesn’t suggest recklessness or fraud liability as the answer.
They were outsmarted.
The rating agency’s goal is to find a metric that enables them to quantify the risk of default on an instrument. But as soon as they have a metric in place, the gaming begins. Loewenstein’s article (which I found unsatisfying because it focuses on only one set of agency problems in a system utterly riddled with them) details how issuers were able to design instruments optimized against the rules used by the rating agencies. In other words, every time a rating agency is too harsh on a proposed instrument, it’s shopped to another agency. Every time a rating agency is too lenient, it’s presented with lots more that have been rigged in the same fashion. To me, the article is a story about how a loose collection of very smart mortgage-packagers found a mistake in the rating agencies’ algorithms, and then systematically exploited it.
This view suggests a few things. First, agencies do need to have their incentives properly aligned with those who rely on ratings. The current system, in which they’re paid by issuers, certainly creates the risk of a structural skew in their outlook. Of course, since ratings are an information good, there’s a standard public-goods problem in having them be paid by the client-side. The “skin in the game” proposals would help, but we could use something further, as well.
Second, it’s far from clear that greater transparency in rating would improve accuracy. If a rating agency is too up-front about the characteristics it’s looking for, it’s an open invitation to loopholing. Maybe we need more opacity, so that issuers would design their instruments based on financial fundamentals, not on the specific criteria used by rating agencies. Think of it as being like the problem of transparency in search algorithms–except that fewer people will shed tears for a financial engineer whose investment vehicle is misrated than would for a web site that’s misranked.
Third, there’s something deeply messed-up about the quasi-official status the rating agencies enjoy. The actual letter-grades matter primarily because some institutions are legally bound to choose investments on the basis of their rating. The rating becomes a substitute for independent judgment.
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