The Signal and the Noise: Why So Many Predictions Fail-but Some Don't

by Nate Silver

If the economy and the housing market are healthy, the first scenario—the five mortgages have nothing to do with one another—might be a reasonable approximation. Defaults are going to happen from time to time because of unfortunate rolls of the dice: someone gets hit with a huge medical bill, or they lose their job. However, one person’s default risk won’t have much to do with another’s. But suppose instead that there is some common factor that ties the fate of these homeowners together. For instance: there is a massive housing bubble that has caused home prices to rise by 80 percent without any tangible improvement in the fundamentals. Now you’ve got trouble: if one borrower defaults, the rest might succumb to the same problems. The risk of losing your bet has increased by orders of magnitude. The latter scenario was what came into being in the United States beginning in 2007 (we’ll conduct a short autopsy on the housing bubble later in this chapter). But it was the former assumption of largely uncorrelated risks that the ratings agencies had bet on. Although the problems with this assumption were understood in the academic literature42 and by whistle-blowers at the ratings agencies43 long before the housing bubble burst, the efforts the ratings agencies made to account for it were feeble.