This development sparked a renaissance in neural network research. Through the 1980s, research moved from the labs into the commercial world, where it has since been applied to solve both operational problems-such as detecting fraudulent credit card transactions as they occur and recognizing numeric amounts written on checks-and data mining challenges.

At the same time that researchers in artificial intelligence were developing neural networks as a model of biological activity, statisticians were taking advantage of computers to extend the capabilities of statistical methods. A technique called logistic regression proved particularly valuable for many types of statistical analysis. Like linear regression, logistic regression tries to fit a curve to observed data. Instead of a line, though, it uses a function called the logistic function. Logistic regression, and even its more familiar cousin linear regression, can be represented as special cases of neural networks. In fact, the entire theory of neural networks can be explained using statistical methods, such as probability distributions, likelihoods, and so on. For expository purposes, though, this chapter leans more heavily toward the biological model than toward theoretical statistics.

Neural networks became popular in the 1980s because of a convergence of several factors. First, computing power was readily available, especially in the business community where data was available. Second, analysts became more comfortable with neural networks by realizing that they are closely related to known statistical methods. Third, there was relevant data since operational systems in most companies had already been automated. Fourth, useful applications became more important than the holy grails of artificial intelligence. Building tools to help people superseded the goal of building artificial people. Because of their proven utility, neural networks are, and will continue to be, popular tools for data mining.

Real Estate Appraisal

Neural networks have the ability to learn by example in much the same way that human experts gain from experience. The following example applies neural networks to solve a problem familiar to most readers-real estate appraisal.

Why would we want to automate appraisals? Clearly, automated appraisals could help real estate agents better match prospective buyers to prospective homes, improving the productivity of even inexperienced agents. Another use would be to set up kiosks or Web pages where prospective buyers could describe the homes that they wanted-and get immediate feedback on how much their dream homes cost.

Perhaps an unexpected application is in the secondary mortgage market. Good, consistent appraisals are critical to assessing the risk of individual loans and loan portfolios, because one major factor affecting default is the proportion

of the value of the property at risk. If the loan value is more than 100 percent of the market value, the risk of default goes up considerably. Once the loan has been made, how can the market value be calculated? For this purpose, Freddie Mac, the Federal Home Loan Mortgage Corporation, developed a product called Loan Prospector that does these appraisals automatically for homes throughout the United States. Loan Prospector was originally based on neural network technology developed by a San Diego company HNC, which has since been merged into Fair Isaac.

Back to the example. This neural network mimics an appraiser who estimates the market value of a house based on features of the property (see Figure 7.1). She knows that houses in one part of town are worth more than those in other areas. Additional bedrooms, a larger garage, the style of the house, and the size of the lot are other factors that figure into her mental calculation. She is not applying some set formula, but balancing her experience and knowledge of the sales prices of similar homes. And, her knowledge about housing prices is not static. She is aware of recent sale prices for homes throughout the region and can recognize trends in prices over time-fine-tuning her calculation to fit the latest data.

Figure 7.1 Real estate agents and appraisers combine the features of a house to come up with a valuation-an example of biological neural networks at work.

The appraiser or real estate agent is a good example of a human expert in a well-defined domain. Houses are described by a fixed set of standard features taken into account by the expert and turned into an appraised value. In 1992, researchers at IBM recognized this as a good problem for neural networks. Figure 7.2 illustrates why. A neural network takes specific inputs-in this case the information from the housing sheet-and turns them into a specific output, an appraised value for the house. The list of inputs is well defined because of two factors: extensive use of the multiple listing service (MLS) to share information about the housing market among different real estate agents and standardization of housing descriptions for mortgages sold on secondary markets. The desired output is well defined as well-a specific dollar amount. In addition, there is a wealth of experience in the form of previous sales for teaching the network how to value a house.

TIP Neural networks are good for prediction and estimation problems. A good problem has the following three characteristics:

The inputs are well understood. You have a good idea of which features of the data are important, but not necessarily how to combine them.

The output is well understood. You know what you are trying to model.

Experience is available. You have plenty of examples where both the inputs and the output are known. These known cases are used to train the network.

The first step in setting up a neural network to calculate estimated housing values is determining a set of features that affect the sales price. Some possible common features are shown in Table 7.1. In practice, these features work for homes in a single geographical area. To extend the appraisal example to handle homes in many neighborhoods, the input data would include zip code information, neighborhood demographics, and other neighborhood quality-of-life indicators, such as ratings of schools and proximity to transportation. To simplify the example, these additional features are not included here.

inputs output

Figure 7.2 A neural network is like a black box that knows how to process inputs to create an output. The calculation is quite complex and difficult to understand, yet the results are often useful.