Tuesday, February 12, 2008

Subprime and Black Swans

It goes without say that the subprime mess is a Black Swan event, though many people will say that it was obvious. (We didn't purchase a home in Va Beach in 2005-2006 because of it.) The abundance of cheap money fueled a bubble. This is a well known phenomenon. It happened with the DotComs and other things. It caught the money people on Wall Street off guard. (Are they ever really on guard?) Everyone was looking to get fantastic returns so they kept pumping money into the system.

Another Black Swan event is the shown in this article from this article of the Financial Times.

Here's a quote:
In particular, it seems that mathematical models used to predict future default rates, based on past patterns of losses, have gone wrong because they did not adjust to reflect shifts in household behavior. Or, to put it another way, financiers have been tripped up because they ignored one of the most basic rules of investment, which is usually found in product literature: the past is not always a guide to the future.

What makes this a Black Swan event is the fact that the models being used didn't take into consideration a potential shift in the way that people value their possessions. A home used to important. It was the American Dream. Homeowners wouldn't stop paying the monthly bill. Money was saved to purchase a place where the children would be raised. Credit cards would be paid last.

Consider the fact that homes have been used as cash dispensers and there was no down payment for most of the non prime loans, people have no reason to stay in the home. From what I've been reading, foreclosure only hurts credit scores for two years so long as all of the other bills are paid on time. People are walking away from what is bad investment. Traders do the same thing with stock why shouldn't regular Joe's do the same thing?

The modelers and their models never considered this change in human behavior. They used the past as a predictor of things to come. It's a past based only on a few years of observation. It's weak and their short sightedness is going to cost everyone big.

(Roubini has some things to say about "Jingle Mail" phenomenon.)

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