Thursday, February 11, 2010

Passion Party #159 - Computers Run Amok

There is no denying that computers have taken over banking, and Wall Street in general.
As we move forward in time, past the Banking Crisis of 2008
and the Great Crash of 2009
it is becoming clear that a root cause of the mess we're in stems from faulty computer models that made people (and banks and investors) believe that a risky transaction would become risk-less if it were sliced and diced enough to become unintelligible to mortal man.

Faulty computer model #1
The Fair Issacs Company (FICO) uses computer models to create a risk-based credit score that banks take as gospel in creating loans. As The Market continued on its frothy way in the early 2000s, FICO discovered an amazing "fact" - that people with a very high credit score historically never default on a home loan, even if they borrow 100% of the purchase price to buy the house.
Viola! 100% financing for "qualified" borrowers ("qualified" at this point equaled a high FICO as the banks had already accepted computer models that allowed them to do "stated income" loans, rather than dealing with those pesky tax returns).
Then somehow, a few months AFTER real estate prices started to drop in 2007, FICO retracted this idea. It seems the computer model was flawed. They discovered that with NO equity in a house, a person with perfect credit had as much likelihood of defaulting as a person with bad credit that put 30 - 40% down to buy a home.
Of course, this was a severe case of "closing the stable door after the horse has bolted".
100% financing had snared many folks into a belief that borrowing money was a way to riches
as opposed to a way to be in debt up to their eyeballs.
(to be continued...)

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