Mysteries of financial risk, plus: House on fire

The idea floating around (one version proposed by McCain) that the government should buy up "troubled" mortgages is as misguided notion as they come. "Troubled" itself is hard to define. Is it determined by the borrowers' difficulties in making loan payments? Or by loan default? Or is it just a mortgage "under water," valued at more than the house it's attached to? "Troubled" should be limited to, at most, the first two cases.

The housing crisis -- or rather, the house financing crisis -- will have, not one, but many endings, covering a range of possibilities:

• Borrowers paying reliably on mortgages "under water"
• Borrowers with payment difficulties who renegotiate their loans (lower interest rate)
• Borrowers in default who might renegotiate or just move out, to rentals
• Borrowers in foreclosure who must move out, or stay and rent with option to buy

At this point, the last category is small, a little over a percent of mortgages. The range of options is enough to make simply throwing people out on the street an unnecessarily harsh choice. Banks and lenders will not want to sit on unoccupied, non-income-generating property in any case. Both lenders and borrowers will unavoidably take some losses along the way.

Except for directly intervening with borrowers with Fannie and Freddie loans, it's hard to see what role government should take here, except to act as a catalyst. Government should certainly not be engaged in perpetuating the housing bubble; for example, in trying to prop up house prices or encouraging any more subprime lending. If it does anything for the housing market, it should be terminating the ingredients that went into the bubble in the first place.

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The general financial crisis, centered in the credit markets and impacting others (like the stock market), was certainly triggered by the weakness in the subprime mortgage market and exacerbated by falling house prices across the board. But the financial system, as evolved over the last thirty years, has developed intrinsic weaknesses of its own that falling house prices merely exposed. Those dangers are embodied in excessive debt and rationalized in turn by faulty theories about controlling risk.

Many of the supposed culprits -- mortgage bonds and "derivative" securities (essentially, complex, composite repackagings of existing securities); the non-existent "deregulation" of Wall Street; and the alleged merging of investment and commercial banking -- are bogus. These supposed factors are either not real or not capable of producing an unforeseeable credit crisis of this magnitude.

Over the last generation or so, the financial world, American and non-American, the regulated and the regulators, has developed an unhealthy and misplaced confidence in its ability to quantify and manage risk. The crisis we see unfolding now has nothing in the slightest to do with "fraud" or malfeasance on any individual's part.* Traditional regulation is designed to deter and punish such misbehavior, which is multiply times over illegal anyway. A crisis of this type is a result of collective misjudgment and collectively-held false ideas about risk, mixed with a certain level of hubris.

Viewed this way, our present financial troubles start to look less like a crime caper and more like the failure of a complex technological system, like the explosion of the space shuttle Challenger or the sinking of the Titanic. Megan McArdle had an interesting post on this point a while back.

To follow Megan, it's especially enlightening to compare the failure of financial risk management with the Challenger explosion, on which topic she recounts the story in Richard Feynman's famous What Do You Care What Other People Think? and captured in detail in Feynman's appendix to the Rogers Commission report. The key comparison: the different ways that different people interpreted "small" risks. Based on decades of prior experience with rockets, the engineers knew in their bones that the "small" risk of a fatal shuttle accident was about one in a 100. (And we know now, with over 25 years of shuttle experience, that they were right.) But they couldn't articulate and defend their point of view in the face of managerial and political figures, whose notion of "small" was more like one in a 100,000 or one in a 1,000,000. Each near-fatal incident, instead of being interpreted correctly as a warning, was instead rosily misinterpreted as "great, we survived another close one" and falsely built up NASA's confidence.

That difference -- "small" as one in a 100 or one in a 1000, versus "small" as one in a million or ten million -- is precisely the difference between the "wild" and the "mild" in risk, "Extremistan" versus "Medocristan." Readers of previous posts on finance and statistics will know of Nassim Nicholas Taleb's The Black Swan and all about such misperception of risk. A one-in-a-hundred incident is something likely to happen more than once in a person's lifetime. A one-in-a-million or ten-million incident is unlikely to happen in anyone's.

It makes the crucial difference to social systems created and run by humans. All of us, especially the college-trained, are prone to the Tyranny of the Cookbook, falsely believing that some answer is better than no answer, even if that answer is wrong. Much of the financial world still wrongly assumes the mild risk of Medocristan and rationalizes the powerful evidence to the contrary by handwaving.
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* It has even less to do with "corruption," something outside of Wall Street's power, since that requires the granting of political favors. You have to look to K Street (in Washington) for that.