Tuesday, January 15, 2008

Subprime failure and Prediction markets

What do the subprime meltdown and Iraq have in common?

Massive failure due to forecast errors.














  1. Not only can economic forecasts be inaccurate. People can often have poor information about the current state of the economy. It is quite common for people to exaggerate fears or ignore problems


  2. "What seems to be failing corporate America is an open framework for capturing that knowledge in a non-biased, confidential manner."

    Thats an interesting comment. I believe corporate America knew full well the quantity of potential loan defaults. It could be my paranoid mind, but seeing ex-CEO CountryWide land ~$87m after exit, makes me wonder why the incentives for failure are so large these days, and the effect they have on using proper judgement in running the business.

  3. Anonymous4:52 PM

    You've nailed the problem with this post. I've always been skeptical of mechanisms based on traditional statistics because of the foundational belief that many things are correlated with a normal distribution. The truth is, many things are not correlated with normal distributions, yet this concept is at the heart of calculations such as VAR and option pricing. These create economic payoffs that work...until they don't. And when they stop working, they crash big time.

  4. Great post.

    Having spent a good deal of my recent past managing technology programs in the mortgage industry, I'd suggest the mortgage problem was a moral problem, or more specifically a moral hazard problem. As this post correctly points out, companies underwriting loans rarely retain the loans. They are packaged and sold as securities. Instead of making their money over the life of the loan from consumers' loan payments (like they used to), underwriters make their money upfront. Whether or not consumers make their loan payments becomes someone else's problem.

    Lenders (and other parties in the mortgage supply chain) can have their profitability with responsibility. Of course, our theory of capitalism would teach that this party eventually has to end: the market eventually wise up and stop buying mortgage-backed securities. And, of course, our theory is correct. The market for these securities did dry up (we have a 'liquidity problem').

    Almost anyone could see this coming, but, like the early-stages of a ponzi scheme, as long as everyone is making money, no one complains.

    The little big question, it seems to me, is whether regulators should have allowed this to happen in the first place. The big big question is whether we want to be a country where people are responsible for their actions, or not? This is essentially a moral question. A question of whether we really are a country about values, or just value.

  5. Nice Post! You have done a great job! I like the way you have discussed the topic! Fore casting is always be the most important thing for risk assessment. And for this we need proper information.