US Homeowners Confound Predictions

The Financial Times is discussing attitudes in Last year’s model: stricken US homeowners confound predictions.

When Ray McDaniel, president of Moody’s, addressed a debate in Davos last week, the mood was so hostile that some speakers joked that he was brave to appear “without a bodyguard”.

“There has been a failure in some of the key assumptions which supported our analysis and modelling,” Mr McDaniel admits. “The information quality deteriorated in a way that was not appreciated by Moody’s or others.” Mortgage borrowers, in other words, did not behave as expected.

When American households have faced hard times in previous decades, they tended to default on unsecured loans such as credit cards and car loans first – and stopped paying their mortgage only as a last resort. However, in the last couple of years households have become delinquent on their mortgages much faster than trends in the wider economy might suggest.

More­over, consumers have stopped paying mortgages before they halt payments on their credit cards or automotive loans – turning the traditional delinquency pattern on its head. As a result, mortgage lenders have started to face losses at a much earlier stage than in the past.

In particular, it seems that mathematical models used to predict future default rates, based on past patterns of losses, have gone wrong because they did not adjust to reflect shifts in household behaviour. Or, to put it another way, financiers have been tripped up because they ignored one of the most basic rules of investment, which is usually found in product literature: the past is not always a guide to the future.

“There has been a failure in some of the key assumptions which supported our analysis and modelling,” Mr McDaniel admits. “The information quality deteriorated in a way that was not appreciated by Moody’s or others.” Mortgage borrowers, in other words, did not behave as expected.

Nevertheless, one thing is clear: the credit crunch will force many institutions to rethink their reliance on backward-looking models and perhaps put a greater emphasis on behavioural economics. “Simply extrapolating from the past into the future is not good enough,” says one US policymaker. Or as the beleaguered Mr McDaniel at Moody’s adds: “We [in the ratings industry] know we have got to retool our processes.”

Failure at Moody's, Fitch, and S&P

Why did the ratings agencies find this so unexpected? If you give a $500,000 mortgage to someone making $30,000 a year, you have to be dense to think they will pay their house before their car. The only way they could make the house house payment was by borrowing against it to pay the bills. How long could that last?

Another reason to pay the car before the house is that down payments went to zero. Again, it should not have taken a genius to figure out that defaults would soar.

The assumptions made by Moody's, Fitch, and the S&P were so ridiculous that the only way they are still in business is by government support. See Fitch Discloses Its Fatally Flawed Rating Model for more about flawed assumptions.

It's only about those who could afford to pay but chose not to, could there have been any excuse for poor assumptions. Even then, the "big three" made enormous failures to account for relaxed lending standards and home prices 3 standard deviations above rental prices and wage growth.

Attitudes Continue To Evolve

Professor Depew was talking about attitudes in Monday's Five Things. Lets tune in to point number three The Sea Change in Social Mood the Models Failed to Predict.

Over the weekend we ran across an interesting article in the Financial Times discussing how it is the ratings agencies failed to accurately predict the wave of foreclosures and loan defaults now spreading across the credit spectrum.

The problem lies, as do nearly all financial problems, with the models. It turns out the mathematical models used by the ratings agencies to predict future default rates simply failed to account for a profound shift in social attitudes.

As Bank of America (BAC) CEO Kenneth Lewis noted recently, "There's been a change in social attitudes toward default." People are walking away from their homes but keeping their credit cards and auto loans.

This is not what the models predicted. Part of the explanation for this is related to the continuing shift in social mood toward debt repudiation and the relative attractiveness of scaled down living. And some of it is simply a rational response to deflation and negative home equity. Why fight to save something that is going down in value?

This, of course, is how a deflationary credit contraction feeds itself. Financial institutions will be forced to update their models to account for shifting consumer behavior. The net result: less credit available going forward.

Secular Trends In Consumption And Risk Taking Have Peaked

• The ability and willingness of consumers to take on debt has reached a secular peak.
• The ability and willingness of businesses to take on debt has reached a secular peak.
• The ability and willingness for banks to lend has reached a secular peak.

In spite of the above, Bernanke does not give up easily. He wants to deal. His working capital is 300 basis points, down from a recent high of 525 basis points. What will 300 basis points buy?

I have it on great authority that Bernanke is willing to offer 250 of his 300 basis points for the right to select what's behind one of three doors. Bernanke Chose Door Number Two. As soon as he gets around to opening that door, a surprise awaits. That surprise is called deflation.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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