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A Longreads Member Exclusive: 
A Catastrophic Failure of Prediction, by Nate Silver


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Introduction

This week we're proud to share a Longreads Member pick from Nate Silver's new book The Signal and the Noise, published by The Penguin Press. Chapter 1, "A Catastrophic Failure of Prediction," comes recommended by Janet Paskin, editor of Businessweek.com, who writes:
 
"Could there be a more appropriate hero for our time than Nate Silver? We can quantify and track and poll and log almost everything—and so we usually do, even if we're not sure how to make sense of it all. But Silver is—or at least, he can tell you exactly how likely it is that he's right. 
 
"His nerd-god omniscience during the 2012 election cycle made him a blast to watch, read and retweet. He was consistent, and he was right, and it made a lot of people think a little differently about the relentlessness of our political pageantry and punditry. 
 
"Here, in the first chapter of his new book, he revisits the housing crash, and the failure of the ratings agencies to spot it. It's not new criticism. Even so, the prediction game is Silver's strength, and he makes the whole thing feel outrageous again. He takes to task the errors in the rating agencies' models and in their psychology. There are charts, graphs, and 101 footnotes, and in the end, it's reassuring: If Silver thinks we can avoid making the same mistakes again—well, even a skeptic like me wouldn't bet against him. After all, he knows the odds better than I do." 

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A Catastrophic Failure of PredictionNate Silver | The Signal and the Noise, Penguin Press | 2012 | 37 minutes (9,052 words)
Illustration by Kjell Reigstad It was October 23, 2008. The stock market was in free fall, having plummeted almost 30 percent over the previous five weeks. Once-esteemed companies like Lehman Brothers had gone bankrupt. Credit markets had all but ceased to function. Houses in Las Vegas had lost 40 percent of their value. Unemployment was skyrocketing. Hundreds of billions of dollars had been committed to failing financial firms. Confidence in government was the lowest that pollsters had ever measured. The presidential election was less than two weeks away.

Congress, normally dormant so close to an election, was abuzz with activity. The bailout bills it had passed were sure to be unpopular and it needed to create every impression that the wrongdoers would be punished. The House Oversight Committee had called the heads of the three major credit-rating agencies, Standard & Poor's (S&P), Moody's, and Fitch Ratings, to testify before them. The ratings agencies were charged with assessing the likelihood that trillions of dollars in mortgage-backed securities would go into default. To put it mildly, it appeared they had blown the call.

The Worst Prediction of a Sorry Lot

The crisis of the late 2000s is often thought of as a failure of our political and financial institutions. It was obviously an economic failure of massive proportions. By 2011, four years after the Great Recession officially began, the American economy was still almost $800 billion below its productive potential.
I am convinced, however, that the best way to view the financial crisis is as a failure of judgment—a catastrophic failure of prediction. These predictive failures were widespread, occurring at virtually every stage during, before, and after the crisis and involving everyone from the mortgage brokers to the White House.

The most calamitous failures of prediction usually have a lot in common. We focus on those signals that tell a story about the world as we would like it to be, not how it really is. We ignore the risks that are hardest to measure, even when they pose the greatest threats to our well-being. We make approximations and assumptions about the world that are much cruder than we realize. We abhor uncertainty, even when it is an irreducible part of the problem we are trying to solve. If we want to get at the heart of the financial crisis, we should begin by identifying the greatest predictive failure of all, a prediction that committed all these mistakes.

The ratings agencies had given their AAA rating, normally reserved for a handful of the world's most solvent governments and best-run businesses, to thousands of mortgage-backed securities, financial instruments that allowed investors to bet on the likelihood of someone else defaulting on their home. The ratings issued by these companies are quite explicitly meant to be predictions: estimates of the likelihood that a piece of debt will go into default. Standard & Poor's told investors, for instance, that when it rated a particularly complex type of security known as a collateralized debt obligation (CDO) at AAA, there was only a 0.12 percent probability—about 1 chance in 850—that it would fail to pay out over the next five years. This supposedly made it as safe as a AAA-rated corporate bond and safer than S&P now assumes U.S. Treasury bonds to be. The ratings agencies do not grade on a curve.

In fact, around 28 percent of the AAA-rated CDOs defaulted, according to S&P's internal figures. (Some independent estimates are even higher.) That means that the actual default rates for CDOs were more than two hundred times higher than S&P had predicted.

This is just about as complete a failure as it is possible to make in a prediction: trillions of dollars in investments that were rated as being almost completely safe instead turned out to be almost completely unsafe. It was as if the weather forecast had been 86 degrees and sunny, and instead there was a blizzard.


From The Signal and the Noise, by Nate Silver. Published by arrangement with The Penguin Press, a member of Penguin Group © Nate Silver, 2012.

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