Stats Analysis of TARP = Paying for Type I Errors

Arnold Kling analyzes the subprime mortgage mess using statistics:

Null Hypothesis: Borrower applying for a loan will NOT repay it.

Alternative Hypothesis: Borrower will repay the loan.

Type I Error: Rejecting the null hypothesis when it is actually true, in this case approving a loan that eventually goes into default.

Type II Error: Accepting the null hypothesis when it is in fact false, in this case denying a loan to a borrower who would actually repay the loan, or making an "error of excessive skepticism," i.e. having credit standards that are too strict.

Other things equal, if a bank tries to make fewer Type I errors by imposing strict credit standards, it will make more Type II errors (rejecting good loans).

Other things equal, if a bank tries to make fewer Type II errors (by lowering credit standards), it will make more Type I errors (accepting bad loans).

In 2004-2007, Freddie Mac and Fannie Mae lowered their lending standards. This meant approving loans with lower FICO scores, along with other methods (mortgage underwriting is based on a number of factors). At the hearing, Congressmen were asking (not in these words), why did you succumb to pressure to reduce Type II errors and increase Type I errors? (MP: By relaxing underwriting standards).

The CEOs said that the market was changing. In the past, when they made Type II errors, nobody saw them. If Freddie and Fannie denied a loan, then the loan was not made. Wall Street was now making loans to borrowers with lower FICO scores, and these borrowers were not defaulting. The Type II errors that Freddie and Fannie were making were more visible than they had ever been before. This made the CEOs question their own credit policies, and they decided to loosen up.

As it turned out, the success of Wall Street's looser lending policies had been due mostly to luck--rapidly rising house prices. Once house prices stopped rising, Wall Street's loans started defaulting. The large number of Type I errors had been exposed. Meanwhile, Freddie and Fannie had loosened up at just about the worst possible time--just as house prices were reaching their peak. They made a lot of Type I errors, for which we as taxpayers are going to pay a steep cost.

HT: Club For Growth