Over-Reliance on Models One Lesson of Subprime Crisis, Actuaries Say

December 10, 2008

An over-reliance on models used in securitizing mortgage risks and a failure to question basic assumptions played a role in the subprime crisis, a panel of actuaries told attendees during the opening session of the Casualty Actuarial Society’s 2008 Annual Meeting, held on Nov. 16-19 in Seattle.

“The models gave the wrong answers and people acted on those answers,” according to David Ingram, senior vice president, Willis Re, who explained that the models overlooked a number of things.

For example, he observed that the models missed that differences in the size of down payments would impact experience; increasing the pool of subprime borrowers would alter the characteristics from the select group of the best subprime borrowers of a few years ago to the riskier group of more recent years; changing the terms of mortgages from fixed rates to gimmicky rates would have a major impact; and there could be a national risk from subprime mortgages.

Ingram noted that “this was not a one in 100, 1,000 or 5,000 event, but a one in one event. The idea of issuing these kinds of mortgages and securitizing them was tried once and it failed out of the box. It never worked at all.”

Panel moderator Thomas Hettinger, managing director, EMB America LLC, observed that it is likely that the debate over the effectiveness of models would evolve into two camps. One is a group of naysayers who say the models didn’t work. “But it’s too complex for most people to get their arms around that easily,” said Hettinger. “We’re going to hear other people say, those models weren’t perfect, but we’ll move on to the next evolution of models,” he said.

Commenting on the increasingly complex nature of risk transfers, Hettinger noted that “as actuaries we have to try to understand the risk transfer and then take it to the next step and opine on it, even though it might not be considered a traditional actuarial analysis.”

Looking back at the decisions made by financial institutions to invest in risky mortgage-backed securities, Don Mango, managing director, Guy Carpenter, asked, “Was there a licensed professional who offered an opinion on the value of the securities, or were the decisions made in the investment banking houses or the rating agencies, which had mixed incentives?”

Mango pointed out that one remedy to the financial crisis is “to take the actuarial profession’s framework – which includes licensed professionals, a code of conduct, codified standards of practice, a discipline process, educational programs, and regulatory recognition – and replicate that in the credit markets.”

Mango predicted that in the next three to six months, the actuarial profession’s contributions will be elevated. “I think the structure of the profession is what we have to offer.”

Source: CAS

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