Saturday, October 4, 2008

Wenzel's Observation #1 and The Econometricians Role In The Mortgage Crisis

Two factors dovetailed to cause the problems that now exist in the mortgage markets. Federal Reserve money printing fueled the mortgage beast and econometricians weighed and measured the beast and called it a Sleeping Beauty.

NYT in a story today reports that there was a problem with the econometric models used by those buying the mortgages:

But Fannie’s computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted [Fannie Chairman] Mudd to buy. Many of them — like balloon-rate mortgages or mortgages that did not require paperwork — were so new that dangerous bets could not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans
This is a point we have been emphasizing for years. The problem consists in the fact that econometricians can't design equations without at least one constant. Since there are no constants in the world of human action, econometricians take a variable that has held fairly constant over some period of time and assume it is a constant. This works fine, and can for long periods of time, until Wenzel's Observation #1 comes into play: Any variable has the potential to eventually start to dance. A dancing variable is one that no longer acts like a constant and moves considerably outside its previous assumed range of movement.

In the case of the mortgage crisis, econometricians assumed a very narrow range of movement for default rates on sub-prime mortgages. What they failed to take into consideration was that in the new world of securitization, many originators of mortgages did not have incentive to carefully analyse the ability of a borrower to pay a mortgage, since the originators sold off the mortgages and simply earned an origination fee, without exposure to default risk. This resulted in originators creating mortgages with the potential for much higher default rates. Thus, the default rates on subprime mortgages started to dance in a dance style not scene since Michael Jackson's moonwalk dance.

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