Collective human phenomena are as a rule tricky to analyze and consequently tough understanding and explaining. The reason is learning. Even if at its core a process remains simple, people learn: they observe how things work and they adapt. Adaptation in its turn modifies the process and initiates an endless dynamics of change. Such feedback makes any human collective process out of necessity complex and renders its account arduous.<\/p>\n
Fortunately, in some cases as in the credit crunch, the mechanism is relatively simple and thus relatively simple to work out. The current crisis is the outcome of a distortion of the insurance principle due to two incidental factors proper to the American environment: the splintering of insurance over a huge collection of \u201cinsurers\u201d and the alternation of periods essentially with<\/em> and without<\/em> claims. <\/p>\n With insurance, the main component of the premium the consumer pays is the risk premium. Its amount reflects the expected loss times the probability of damage. The insurance principle holds water for two reasons: first because damage is sparse and second because the insurer is present for the long haul and therefore in a position to back the losses incurred with the proceeds from the premium paid by consumers with no claim.<\/p>\n A mortgage\u2019s rate encompasses also a risk premium while at the same time the insurance perspective is twisted for the two reasons mentioned before. On the one hand, the good health of housing is, if not cyclical, submitted at least to an alternation of times with and without claims clustered together. In favorable times nearly all borrowers are able to repay their loan (as the price of housing keeps going up, providing the safety exit of selling the house at a profit); by contrast, in an unfavorable climate, many borrowers fail to make these payments (as in this case the price of housing is dropping). On the other hand, the \u201cinsurer\u201d isn\u2019t in for the long haul but is splintered between a multitude of investors in Mortgage\u2013Backed Securities<\/em> (MBS) or Asset\u2013Backed Securities <\/em>(ABS).<\/p>\n A mortgage\u2019s rate encompasses a risk premium calculated over the long run with the alternation of phases of low and high default rates. With low default, the risk premium is over-valued: losses are at a minimum and investors benefit from the favorable risk arbitrage. This is the time when Wall Street firms vied for ABSs comprising scores of high-yield subprime loans and used them as stuffing for the Collateralized Debt Obligations<\/em> (CDOs) they were issuing. Conversely, in the bottom part of the business cycle, when the price of housing is dropping and a large number of borrowers default on their loan, the risk premium is under-valued as it fails to compensate for the losses effectively incurred. This is when on the secondary market sellers are forced to discount those securities to make them competitive or, which amounts to the same, need to boost their spread to Treasuries<\/em>.<\/p>\n So to recapitulate, within the American housing context, the insurance principle got distorted by two intervening factors: the business cycle or pseudo-cycle and the splintering of the insurer\u2019s position. What this means is that, unlike what is being repeated these days, no contagion is at work in the credit crunch. What is happening instead is that \u2013 due to the drop in housing price \u2013 every subprime loan comes with an under-valued risk premium and that under-valuation sticks to it wherever it may hide, be it as a component of an Asset\u2013Backed Security<\/em>, as stuffing in a Collateralized Debt Obligation<\/em> or as commercial paper<\/em>; the guise doesn\u2019t matter, what does matter is the under-valuation: that the premium doesn\u2019t cover the risk!<\/p>\n","protected":false},"excerpt":{"rendered":" Collective human phenomena are as a rule tricky to analyze and consequently tough understanding and explaining. The reason is learning. Even if at its core a process remains simple, people learn: they observe how things work and they adapt. Adaptation in its turn modifies the process and initiates an endless dynamics of change. Such feedback […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_crdt_document":"","footnotes":""},"categories":[5,6],"tags":[],"class_list":["post-63","post","type-post","status-publish","format-standard","hentry","category-economy","category-finance"],"_links":{"self":[{"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/posts\/63","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/comments?post=63"}],"version-history":[{"count":0,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/posts\/63\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/media?parent=63"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/categories?post=63"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/tags?post=63"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}