The Problem With Basing Worst-Case Scenario On a Past Extreme

I will start with a quote from one of my favorite authors: Nassim Nicholas Taleb. In his new book, Antifragile, Taleb writes

[R]isk-management professionals look to the past for information on the so-called worst-case scenario to estimate future risks – this method is called “stress testing.” They take the worst historical recession, the worst war, the worst historical move in interest rates or the worst point in unemployment as an exact estimate for the worst future outcome.

But they never notice the following inconsistency: This so-called worst-case event, when it happened, exceeded the worst case at the time. I have called this mental defect the Lucretius problem, after the Latin poetic philosopher who wrote that the fool believes that the tallest mountain in the world will be equal to the tallest one he has observed.

You might ask what does this have to do with house prices in Norway? It's hard to blame anyone limiting their imagination to past extremes, when real house prices, ratio of house price to rent and ratio of household debt to income keep on breaking past records with nearly every month that passes. For more on these statistics, see a great paper, "Housing Bubbles and Homeownership Returns", from Marius Jurgilas and Kevin J. Lansing (2012) of Bank of Norway / San Francisco Fed. It's essential reading for anyone interested in the current situation. And by the way - and this applies especially to the "post-Reinhart-Rogoff era" - if an economics writer concludes that "Time will tell whether things turn out differently for the Norwegian housing market", you can fairly safely assume he/she suggests it's a bubble. They can't say it clearer than that if they don't want to risk public humiliation in the case the prices keep on soaring for five more years.

Now back to the title of this post. What I refer to with the "past extreme" is the banks' losses on mortgages in the last house price crash of the late 1980's. Despite a 40-50 % price decline, the credit losses for banks were minimal. You can call it "high Nordic morale" or "bad legislation favoring creditors", but people here will try to meet their loan commitments as long as they can afford to buy some food (or perhaps they would even steal food rather than miss a payment to the bank?).

The fact above has been widely applied as a kind of worst-case scenario, leading to a conclusion that the banking system is robust despite all-time-high household debt levels. Where does a conclusion that the banking system is robust and that mortgages have never created significant credit losses lead us? It leads to

1. low risk-weighting (loss expectations) for mortgages,
2. banks lending more and more (and more) to these "AAA-rated" households (banks make their profits mainly through lending, after all), and
3. finally to testing if the previous worst-case was really the worst possible (even if it was, see the problem I brought up in a previous post).

I applaud the latest move from Norwegian government to raise the mortgage risk weights to 35 % as an essential action to curb lending, but I remain very skeptical when it comes to the relevant question: Is it already too late in order to avoid a bubble? As far as I know, the authorities around the world have always been several steps behind in these situations. To me it makes sense that since it's so hard to tell a bubble (otherwise we wouldn't have them), at the time the authorities are confident enough to take tough actions the bubble is already too apparent, and so the actions from authorities serve rather as a pin to burst the bubble. In trying to be counter-cyclical, the authorities many times end up being pro-cyclical. But perhaps this time is different?