Saturday, November 24, 2007

Thoughts on the Subprime Crisis

Written By Drew Vincent

For anyone interested in economics and finance (and especially for those of us who are American) the past six months have provided a fascinating, perhaps textbook-worthy insight into the dangers posed by the subprime market. The effects of the crisis are broad and well-publicized, but the causes remain quite open to speculation. Many have criticized the increased securitization of subprime lending (up to 62.5% in 2002 from 31.6% in 1994)1 for its creation of tranches with seemingly inflated credit ratings. Following the crisis, I became interested in how such errors in credit assessment might occur even in a relatively static market, as well as how other factors might influence the default rate over time but remain overlooked by financial institutions.

In trying to understand how so many financial institutions were, to put it bluntly, caught with their pants down, I focused first on the way in which these institutions assess risk. Most of my insight into this field comes from the work of mathematician Benoit Mandelbrot. Mandelbrot has studied market behaviour since the 1960s and recently crystallized some of his ideas in a new book, The (mis)Behaviour of Markets. He criticizes the tools he has observed in use at the majority of corporations and financial institutions, namely the Capital Asset Pricing Model (CAPM,) Markowitz Portfolio Theory, and the Black-Scholes formula*2; furthermore, he denounces more recent inventions of mainline financiers (one of these being GARCH,) saying “...such ad hoc fixes are medieval.*3” Mandelbrot's central argument is that 'orthodox' financial theories fundamentally underestimate volatility. Taking equities as an example, the traditional idea is that prices variations lie within the normal curve, infinitely familiar to anyone who has taken a statistics course. This means that small price changes are quite common, with large changes being quite rare. Indeed, this concept is taught today at the LSE, along with the idea that prices change via a random, coin-flip process with no connection between one change and the next.

Numerous events, some of them occurring notably during the subprime crisis, seem to refute the normal curve model of price changes. The most clear example was the market crash of 1987, where the DJIA lost 29.2 percent of its value in one day. Under the normal curve model, a change this extreme is, for all practical purposes, statistically impossible; thus, it seems likely variations lie within a different function: a power law function, Mandelbrot suggests*4. It can also be shown that the coin-flip or 'random walk' model of price changes simply does not produce charts that mimic actual price charts. Mandelbrot provides compelling evidence that these changes can be modelled much more accurately using fractals, geometric constructs that are self-similar regardless of scale (daily behaviour resembles monthly resembles yearly behaviour,) and generate charts with the degree of randomness observed in actual price charts, as well as many other types of sequential, random movements, perhaps including default rates. Fractals are already in wide use providing convincing computer generated images for theatrical special effects, and it is highly likely that fractals could provide a much more reliable system for assessing risk. Unfortunately, the mathematics involved with these models are more complicated than those in CAPM and its companions. For the time being, if Mandelbrot is correct, financial institutions will likely continue to underestimate risks and volatility (at least mathematically.)

Another possible factor influencing default rates is the continuance of widespread illegal immigration into the United States, as well as the government's seeming inability to address this issue. As of January 2006, the US Department of Homeland Security conservatively estimated the population of unauthorized immigrants at 11,550,000*6. These immigrants represent a large market, and banks have been lining up to offer their services. As reported on CNN.com, “an increasing number of banks are seeing an untapped resource for growing their own revenue stream and contend that providing undocumented residents with mortgages will help revitalize local communities.”*7 One bank representative claims that illegals are “no more likely to default than a documented resident.”*8 I find this extremely difficult to believe based on the current political climate and personal experience.

Illegal immigrants and the companies who employ them face increasingly difficult odds as their presence becomes more widely felt and governments begin to respond. For example, my own home state of Georgia recently passed legislation that denies public benefits to undocumented workers and imposes severe punishments on companies found employing said workers. Such actions are likely to cause job loss for illegal immigrants (whose positions were already unstable as they could be terminated randomly with no legal recourse) as well as family troubles as benefits disappear. Both of these are denoted as 'trigger events' for default in the Danis and Pennington-Cross paper on sub prime mortgage delinquency*9. Having worked in the construction industry for two summers, I have heard many of these concerns voiced by both contractors (who face prosecution for employing illegals) and workers who admitted they were not legal residents. One man I worked with quite often, who came to America illegally but was later granted legal status, frequently lamented his credit score as he had in earlier years been forced to default on a mortgage as a result of his uncertain financial situation.

In conclusion, I could not hope to develop an exhaustive explanation of the subprime crisis. However, I hope to have shown that factors such as systemic underestimation of volatility in various markets and banks' lending to undocumented workers merit further investigation as likely contributors to the institutional crisis observed this year. It is my hope that even if the crisis does not prompt reform of the mathematical tools of financial institutions, perhaps it will at least increase the instinctive caution of those considering investment in the subprime market.

1. Danis, Michelle A., and Pennington-Cross, Anthony. “The Delinquency of Subprime Mortgages.” Journal of Economics and Business In Press, Corrected Proof (2007).
2. Mandelbrot, Benoit, and Hudson, Richard L. The (mis)Behaviour of Markets. New York: Basic Books, 2004. 60.
3. Ibid, 104.
4. Ibid, 13.
5. US Department of Homeland Security, 2007. “Estimates of the Unauthorized Immigrant Population Residing in the United States: January 2006,” http://www.dhs.gov/xlibrary/assets/statistics/publications/ill_pe_2006.pdf
6. Pasha, Shaheen. “Banking on Illegal Immigrants.” CNNMoney. 8 August 2005 http://money.cnn.com/2005/08/08/news/economy/illegal_immigrants/
7. Ibid
8. Georgia General Assembly. Senate Bill 529. http://www.legis.state.ga.us/legis/2005_06/fulltext/sb529.htm
9. Danis, Michelle A., and Pennington-Cross, Anthony. “The Delinquency of Subprime Mortgages.” Journal of Economics and Business In Press, Corrected Proof (2007).
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please comment......

4 comments:

tang said...
This comment has been removed by the author.
tang said...

several things:

1) subprime should be one word

2) although i found his research on the normal curve to be very interesting, it seems that the author has somehow missed the point... in an article which claims to discuss credit rating, the lack of mention of ANY credit rating agencies is a strange choice... also, he touched on credit tranches but did not choose to elucidate further (it plays a role in why the normal curve may not be a suitable model??)

3) the rather strange mention of illegal immigrants... I think those paragraphs might need to be carefully reworded before it can be published (...if at all?) since it's a touchy issue... Surely, we should blame the BANKS for lending to illegal immigrants rather than ALL the illegal immigrants going into the States and stealing their jobs (or whatever sentimental/ non-economic rationale)... and even then, we can perhaps blame Greenspan for cutting the interest rates, and then raising them again!... or for the lack of government regulations on lending... or for the return differentials between securitised bonds and other assets which *made* unsecured loans attractive in international capital markets...!

What I'm trying to say is, of ALL the reasons to pick, the ones chosen by this author seems...not convincing enough.

Sorry for being harsh, but if someone who don't really know about this matter feel this way, I'm sure many actually finance aficianados would feel even more strongly on this subject.

Avnish said...

firstly, i believe his article isn't taking any stand whatsoever, it barely touches on the causes and what effect the subprime meltdown has had..
secondly, plz ask him to clear his stance, and perhaps expand on the immigrant theory rather than talking so much about the mathematical models..
if he dsnt want to edit, we could take the other article..

SG said...

i agree with serena and avnish,
tho i think being more opinionated than factual, i think the immigration theory is something that he has touche don and shows his personla inclinations....
it can be made such to show that is what the author of the article thinks and not the magazine...