Malaise in the subprime sector

In today’s Wall Street Journal, Alex J. Pollock a former President and Chief Executive Officer of the Federal Home Loan Bank of Chicago wrote a piece on the subprime industry, I wrote to the Journal’s editor, the following letter:

“In his “Credit Crack-Up” (March 12, 2007), Alex J. Pollock offers a perceptive summary of the current malaise in the subprime mortgage industry. Some of his comments however call for qualification.

1. The risk of “punishing of the innocent along with the guilty”

Some segment of the subprime industry falls unfortunately under the category of “predatory lending” where the lender seeks his profit not, as in normal circumstances, in the interest being charged but in the equity locked in the property and attempts in fact to force repossession. In a speech he made in 2004, Edward M. Gramlich, a Governor of the Federal Reserve, complained that “despite […] actions by the Fed and other bank regulators, we still have no obvious way to monitor the lending behavior of independent mortgage companies” (*), which at the time represented 12% of originations in that sector.

2. “How could all these problems arise […] given our massive computer power manipulating mortgage data with sophisticated models built by mathematical experts?”

No amount of computer power and mathematical expertise will ever allow to bridge safely from observations of the past to prediction of the future. A majority of the mortgage products currently offered to the consumer are of recent invention and have only a short track-record from which to extrapolate. The FICO score has shown a remarkable efficacy at predicting borrower default. Its power derives from assuming that consumers’ past credit behavior along with the current servicing of their debt predicts accurately their future credit behavior. This simple assumption neglects however that the wider economic context, such as the current level of interest rates or of unemployment, has an influence on consumer creditworthiness and the fact remains that the FICO score has never been tested over a full business-cycle including a recession. The “traditional” threshold of 620 FICO points that the industry had adopted as marking the border between subprime and prime has in the past few weeks been raised by lenders to 660; the move is no doubt prudent but it is not based on any objective measurement: new developments only will eventually reveal if the new value was too conservative or still too low.

3. “The belief that the economy has changed in some fundamental way, and that a ‘new era’ is beginning”

The single true danger lies here precisely. Because it has no choice but to extrapolate from historical data, the mortgage industry is bound to develop new scenarios whenever new circumstances dictate. If we keep in mind that what we see now may only reflect the favorable part of the business cycle, we will envisage consumer behavior within that context and remember that a downside remains possible in the future. If on the contrary we assume that a “new era” has opened where business cycles are a thing of the past or, which amounts to the same, that the favorable part will last forever, then we haven’t seen the end of our troubles.
But are we justified to blame mortgage bankers for having trumpeted the arrival of a “new era” in consumer credit? In its most recent guise, the “new era” theme was once again reborn from its ashes as the “optimal allocation of financial risk,” where risk migrates automatically to those parties ideally suited to take it. Its advocate was of course no less an authority on these matters than the former Chairman of the Federal Reserve, Alan Greenspan.”

(*) Edward M. Gramlich, “Subprime Mortgage Lending: Benefits, Costs, and Challenges”, May 21, 2004

Optimistic and pessimistic views on immortality

Religions are most often associated with a representation of the after-life where immortality, which is clearly unattainable in the nether-world, is ultimately achieved.
Other widely held belief systems don’t share that view, in particular Taoism, the “atheistic religion” or “philosophy” of the Chinese people over the ages. Indeed, some disparagingly called “superstitious” versions of Taoism put the stress on attaining immortality in our everyday world, recounting numerous tales of princes going to great length to secure lifesavers of various kinds. In the West, alchemy shared that same concern, being not only focused on the transmutation of antimony into gold but also on the achievement of immortality, either under the highly idealized form of a perfect identification with the person of Jesus-Christ or under the more prosaic form of the incorruptibility of the material body. Cagliostro and the count of Saint-Germain, among others, allegedly realized this aim. The British anthropological school of hyper-diffusionism, widely popular in the 1910s and 1920s (Sir Grafton Elliot Smith, William J. Perry et al.) held that culture had spread at the surface of the Earth as a consequence of the more advanced civilizations’ quest for lifesavers, the ancient Egyptians most prominently.
World representations entailing that immortality is only achievable in an after-life clearly constitute the pessimistic version of the more upbeat assumption that immortality is attainable in the material world that we’re familiar with. Now that medicine and biology are on the eve of making immortality a reality, the final push will no doubt come from these cultures which consistently envisaged immortality as an achievable pursuit: they are unencumbered by the pessimistic view that the only desirable form of immortality is the one requiring us to first die.

The safest financial world of all

A recurrent theme in Alan Greenspan’s speeches, either when he was head of the board of governors of the Fed or now in his capacity as an invited speaker, has been that the financial world has become in recent years a much more sturdy, much more robust and let’s say it, a safer place, because risk has been redistributed and has essentially found its way to the hands of the investors optimally fit to manage it.

There are two notions in Greenspan’s statement, neither of which in my mind is true. The first is that risk has been redistributed and the second is that it has found its way to the investors best fit to manage it.

The part that is certainly true is that securitization of debt has allowed debt to be repackaged, time-scheduled and customized in an infinite number of ways. To that extent, the tools required to redistribute financial risk have no doubt been created over the past twenty years. The additional condition that needs to be met is that risk has been therefore effectively redistributed. The fact is however that none of this repackaging and customization has prevented the glitzy debt instruments to end up in the portfolios of a somewhat restricted number of actors: life insurance companies, pension funds, hedge funds and foreign central banks. This means that – for all practical purposes – that immense potential for redistribution ends up in concentration in the same few hands.
Similarly for the notion that the current investors in these debt instruments are the optimal managers of their underlying risk. Let’s imagine for one second that these investors are all using securitization as the way for them to hedge some market position they need to hold otherwise and that they’ve found that way the ideal method for offsetting two types of risk while, hopefully, at the same time locking a small but risk-free profit.

But as we know very well, this is not the way things actually work: every one of the traders working for these investors holds a call option, getting a share of whatever profit she or he is making while being shielded from the losses … until she or he gets fired, that is.

Risk has been splintered no doubt, whether it has found its way to its safest havens is where Alan Greenspan and I may differ.

Artificial reason and the heart

So, Marvin Minsky has just published a new book called The Emotional Machine (Simon & Schuster 2007) where he states that Artificial Intelligence should rest on the observed feature that intelligence is emotional by nature. This of course rings a bell, as some twenty years ago an audacious AI engineer, traveling between Martlesham Heath (Suffolk) and Paris (France), wrote ANELLA (Associative Network with Emergent Logical and Learning Abilities), a piece of software mimicking logical reasoning on a body of knowledge it had constituted through asking questions only. I say “mimicking” as there were no rules of logic in ANELLA; whatever logic could be seen was generated by ANELLA’s affect dynamics and driven by the feedback it was receiving from its users.
The author of ANELLA was your humble servant indeed, having been granted at the time an Academic Fellowship by British Telecom.
In those days, the single psychological school having paid attention to emotion as the driver of human intelligence and of human behavior altogether was of course psychoanalysis. In 1987 I was both writing AI source code and training to become a psychoanalyst: ANELLA allowed me to combine both. In that same year I published in L’Âne, the literary magazine led by Judith Lacan-Miller, “Ce que l’Intelligence Artificielle devra à Freud”: “What Artificial Intelligence will owe Freud”. Three years later my book Principes des systèmes intelligents came out where I described ANELLA’s philosophy and concept. The book has become, to its author’s delight, a minor classic. No doubt that Minsky’s call to arms will mean that flocks of English-speaking publishers will now vie to publish this pioneering work in their native idiom!

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