Tuesday, September 6, 2011

Cause of the Great Recession (1998-?) and Importance of the Histogram

The Great Recession was caused by a bad histogram.  That is what I tell my students in my data analysis class.  All financial institutions create histograms showing their projected profits/losses, along with the probability of a particular profit or loss.  To determine how much collateral they should hold in case the unlikely chance of a large loss occurs, they look at the first bars on the histogram.  If it says there is a 5% change of losing $1 million or more, they may decide to hold $1 million of collateral.

But their histograms were faulty.  Consider one reason why.  AIG had insured lots of mortgages, without really looking at what mortgages they insured.  When the insurance policy was granted (what they call a CDO), they thought sub-prime loans (the risky loans) comprised 10% of the loans they insured, when in reality it comprised 85%!  Their histogram of projected profits was bad, because they didn't investigate what they insured well.  See page 201 of All The Devils Are Here.

Now, as to why they didn't investigate the mortgages better, I have no good answer.

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