Monday, July 6, 2009

Rising Markets Create Lender Losses

People anticipate the future will be like the past. From a DNA article, “Why Economists Can’t See a Recession Coming”:

Robert J Barbera, chief economist, Investment Technology Group, in his book The Cost of Capitalism -- Understanding Market Mayhem and Stabilizing our Economic Future, writes: "Since the economy is not in a recession 80% of the time, the safe strategy is to predict recessions only when they have already arrived! That means you're right 80% of the time. Simply put, forecasting the recent past is the way to go and it is the dominant strategy employed by professional forecasters…Most of the time, tomorrow bears a close resemblance to yesterday. After all, both industry and economic trends tend to last for years, not for days. Once we acknowledge that we confront a world of pervasive uncertainty, it is quite reasonable to decide until circumstances change, we will plan as if present circumstances are likely to persist."

This approach to forecasting guarantees lenders will take losses. If you don’t say no when markets are rising, you are certain to have significant exposure at the top of the market which will create losses when the market softens. This time around, although everyone knew at an intellectual level that home prices could go down, the long term trend of rising house prices made it easy to justify rating models and lending decisions which didn’t adequately weight this possibility.