Sam Savage’s new book Flaw of Averages has a brilliantly simple explanation of why volatility in the housing market caused such problems for banks recently. When housing prices drop, more people default on their mortgages and obviously that hurts banks. But banks are also in trouble when the housing market is volatile, even if on average house prices are good.
Suppose there’s no change in the housing market on average. Prices go up in some areas and down in other areas. As long as the ups and downs average out, there should be no change in bank profits, right? Wrong!
When the housing market goes up a little bit, mortgage defaults drop a little bit and bank profits go up a little bit. But when the market goes down a little bit, defaults go up more than just a little bit, and bank profits go down more than a little bit. There is much more down-side potential than up-side potential. Say 95% of homeowners pay their mortgages. Then a good housing market can only improve repayments by 5%. But a bad housing market could decrease repayments by much more.
In mathematical terminology, the bank profits are a concave function of house prices. Jensen’s inequality says that if f() is a concave function (say bank profits) and X is a random variable (say, house prices) then the average of f(X) is less than f(average of X). Average profit is less than the profit from the average.