The Pebble and the Avalanche

Norma on Wall Street

I've just spent some time puzzling over my paper copy of the Wall Street Journal; there's a version online here. The article explains how Norma, a New York company, created a series of financial instruments based on the disaggregation of risk. The problem, according to the article, is that the risk was insufficiently disaggregated and that instead of mitigating risk the financial instrument magnified risk.

I am still trying to undertand all the machinations — how did Wall Street firms manage to resell the same risk three times? — but the article makes interesting reading. Reading between the lines of the Wall Street Journal's style, I think the Journal believes there's been criminal misconduct; this article reminds me of the one that exposed outright fraud at L&H.

Topics:  · finance

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Five New Ideas for Mortgage Innovations

Forbes has a fascinating article about mortgages and the lack of innovation.

Certainly we've seem some innovation in the mortgage industry, as mortgages were disaggregated into separate parts, re-bundled, and sold in different ways, but all almost that innovation was focused on post-mortgage processing, and the core mortgage has remained substantially the same. In the Forbes article, Bernard Condon argues for even more disaggregation. For example, at present the homeowner owns all the appreciation of the value of the house; why not let investors purchase some of that appreciation in return for lower interest rates?

I don't agree with all of Mr. Condon's rosy suggestions; I strongly suspect that some of the innovations he proposes would, if implemented, quickly degenerate into schemes to squeeze more money out of mortgage holders. But the fundamental ideas are sound, and Mr. Condon's main point is quite germane: Why is there so little true innovations in mortgage contracts?

Topics:  · finance · innovation

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Shared Financial Risk: Possibly Good Idea, But Terrible Execution

The Centre for Economic Policy Research proposes that "risk" be "shared" when a company sells securitized financial instruments. The basic idea is that if the seller makes an error in evaluating the risk involved, the purchaser isn't the only one to suffer.

On first glance, I can argue that they're proposing disaggregation of ownership. Instead of an absolute sale, with ownership as a monolithic block, the ownership will be parceled out among various buyers. (Of course, this is the entire idea behind securitized mortgages in the first place, and explains why the revolution swept the financial industry.) When I first read this article, I couldn't decide if the ideas it describes were very good or absolutely terrible. After some consideration, I've decided that the ideas are possibly correct but the proposal for how to execute them in practice is absolutely terrible.

At present, there's nothing (aside from government regulations, perhaps) that restricts the buyer and seller from sharing ownership of the security, or at least sharing risk; they can write the contract however they please. They haven't done so in the past, because ownership of these types of objects seems to work better when ownership is absolute. Caveat emptor isn't just an empty phrase; my ability to sell an object as a complete object, without reference to any prior ownership, is one of the foundations of modern capitalism and carries with it the obligation on the buyer to perform due diligence.

This proposal strikes me as remarkably superficial and not fully thought out. Who will enforce the amount of risk that must be shared? The government, of course; this will inevitably impose a huge financial burden on sellers and buyers as well as provide a playground for post-hoc lawsuits. Other problems abound; for example, If company A sells a security to company B, and then company B sells it to company C, who is responsible for explaining the risk to company C?

Finally, the real question is whether or not this law would possibly have made any difference to the current "crisis" and whether it would actually avert a future crisis. The sellers, buyers, and everyone in between made mistakes in judgment about the risks involved; they're all paying the price; what difference would this proposal make?

Topics:  · business · finance · government

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Your Debt vs. Your Real Debt

Regardless of what your credit card agreement or mortgage loan documents might say, federal, state, and local laws strongly determine your obligations to your lender. There's a paper version of the obligations vs. the real obligations; they're disaggregated from each other, and the relationship between your paper obligations and your real obligations continues to change.

A couple of years ago credit card companies, after years of handing out credit cards like candy to children, faced the typical aftermath: rising defaults and bankruptcies resulting with lower profits. The companies adopted a novel approach to the problem: they persuaded Congress to alter the laws of bankruptcy filing. Your debt, which you'd assumed under one set of rules, was suddenly governed by a very different set of rules, and this helped prop up the profits of the lenders.

Now the wheel has turned again. Today's Wall Street Journal (page A6) reports that Congress may consider another round of reforms in bankruptcy laws; for example, judges may be allowed to re-write the terms of a mortgage loan and bankrupt borrowers might once again be allowed to write off certain debts. Lenders, as might be imagined, are attempting to defend the gains they made two years ago.

I find the interplay of the various type of disaggregation in the mortgage and credit industry to be quite complex. In this particular case, the authority to alter the terms of debt obligation — the collection practices, the maximum legal rates, and the use of bankruptcy to dissolve debt — is shared between the government and the lenders, and this sharing relationship isn't a partnership but a contest. It's an unusual situation that's worth watching.

Topics:  · finance · government

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Derivatives and Disaggregation

I understand financial derivatives as a form of disaggregation. In the case of mortgages, for example, there was once a very rigid connection between the mortgage, the homeowner, and the lender. In recent years, the mortgage as a financial instrument has undergone remarkable disaggregation. Bundles of mortgages can be bought and sold to mitigate risk; the interest portion of the mortgages can be sold separately from other interests, which allows investors to speculate on interest rates or hedge risks; and so on and so forth.

As a result, mortgages became available to lower-income and more risky borrowers. Forget about the recent spate of news reports about crooked mortgage brokers; such people have always existed, and the press loves a negative story. Derivatives provide excellent benefits and they're here to stay.

Topics:  · finance

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Ghost Mortgages: Was New Century Plagued by Fraud?

This is a tale of disaggregation, fraud, and meaningless numbers.

First, the disaggregation. New Century Financial Corporation, which is now struggling in its subprime mortgage market niche, specialized in the financial end of the mortgages and relied on hundreds of small brokerage firms to actually sell the mortgage. This is familiar business model — the disaggregation of sales, marketing, and manufacturing — and often a quite successful one.

But what happens if the mortgages are made to ghosts? According to the Wall Street Journal [the online version is subscription only, sorry!], a substantial fraction of the mortgages were made to people who never even made their first payments:

Borrowers failed to make even the first payment on 2.5% of New Century's loans.

Since most people who borrow in good faith will typically make at least a few payments before defaulting, the Journal raises the suspicion that New Century was careless in its selection of mortgage brokers and as a result suffered fraud.

I'm going to raise two different issues. First, disaggregation almost always requires some feedback, some way of tying the disaggregated parts together. If I decide to make bolts in one factory and nuts in another, I need to find a way to test to make certain the nuts and bolts fit together. Similarly, if New Century decides to allow outside brokers to sell New Century mortgages, then New Century must make certain that the mortgages these brokers generate meet New Century's standards.

Secondly, the number "2.5%" is utterly meaningless without any context. What is the first-payment default rate for "normal," non-sub-prime mortgages? What is the rate for other sub-prime mortgage lenders? Without any context, I don't know if this shocking number represents the worst in the entire sub-prime loan industry — or the very best. And given that New Century turned a profit until its recent problems, it may be that their business model allowed them to absorb the costs of a higher-than-usual rate in return for a higher number of profitable mortgages. That is, they knowingly accepted a higher rate because it permitted them to capture higher profits by reducing overall costs and increasing overall sales.

So, while the Journal article is filled with the usual pathos of senior citizens who can't afford their mortgage payments, one of the central indictments of the article — that New Century allowed itself to be defrauded, and that the fraud they permitted was bad for the company — remains unsupported to date.

Topics:  · finance · security

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US Automakers and the Dealership Reservoir

Although the Big Three automobile manufacturers in the US continue to struggle, they do have one terrific advantage: the network of car dealerships. The automakers manufacture cars and then send them to the dealerships, who arrange financing for the cars and absorb the output. This disaggregation between manufacturing and end-user sales is a very common arrangement in any industry, but in the case of automobile manufacturing, the system has failed for lack of feedback.

The automakers use this system to insulate themselves from market realities. They pressure dealerships to accept the automobiles they produce, and since the dealerships bear the cost of unsold vehicles, the automakers are insulated from marketplace signals about how well their vehicles are selling. Unlike a Wal-Mart or a Target, the dealerships cannot go to dozens of competing suppliers; the US has only three "domestic" automobile manufacturers. If the automaker sends a car in an unpopular configuration, such an unpopular size of wheels or an engine that is too large or too small, the car sits in the dealer's lot for months on end.

In essence, the dealership system acts as a reservoir for the automobile makers where automakers dump their unsold cars. The problem is that this reservoir is expensive to operate — for the dealerships — and the dealerships are starting to revolt against the system.

But with the rise of dealership chains, this reservoir system is about to end. AutoNation, which owns many stores across the US, has decided to take the automakers to task and is starting to demand that automobile manufacturers send it cars that are popular with AutoNation's customers [WSJ, subscription] instead of whatever cars are easiest for the automakers to produce. AutoNation is attempting to introduce stronger and more robust feedback into the disaggregated supply chain, and it will be interesting to see what the result will be.

Topics:  · business · finance · transportation

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Milestone for Innovative Company

A while back I discussed Prosper, a company that redefines how to make loans.

Prosper now claims 100,000 members and has facilitated $20 million in loans; these numbers establish Prosper as a solid company with excellent future prospects.

Topics:  · finance

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How to Replace Wal-Mart and Target

Christensen explains in The Innovator's Dilemma that as companies grow, they abandon opportunities that aren't large enough to relative to their size. A million-dollar opportunity that would make or break a small business becomes too small to occupy a top executive's attention.

Wal-Mart and Target started out by catering to shoppers who want inexpensive goods, but now that the companies have grown and the market is saturated, revenue growth must come from elsewhere. Dozens of news stories discuss how Target and Wal-Mart now pursue a more fashionable — and profitable — upscale market far from their original roots: the companies introduced lines of fashionable clothing for women, with Target succeeding and Wal-Mart struggling.

The very success of Wal-Mart and Target will drive them out of their original business segment. The companies successfully disaggregated and then conquered a particular market, the value-oriented shopper; now the value-oriented shopper can no longer sustain the companies' revenue targets. Wal-Mart and Target have started to move on, and unless they can somehow maintain their hold on the value-oriented shopper — a task that's possible in the short term but probably impossible in the long term for such large corporations — a new ecological niche will soon appear.

Who will replace Wal-Mart? Who will replace Target? I suspect that it will be a Hispanic-owned corporation that expands from its niche of serving value-oriented shoppers in immigrant communities and reaches a wider urban market. In Chicago, I've notice the emergence of several larger Hispanic-oriented, value-shopper malls; I would not be surprised if one of them displaces Wal-Mart and Target from their current niches a decade from now.

Topics:  · business · finance · marketing · predictions

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Another Mortgage Scam

During a lecture I gave earlier this year, I was asked about the effects of disaggregation on the finance industry, and I answered by pointing to the increasing specialization in the industry.

As might be expected, criminals have found gaps in the system. An article in the Wall Street Journal and elsewhere details an alleged mortgage scam in Virginia. After you disaggregate, you must take care that your interfaces remain intact:

Fraud has proliferated as lenders increasingly deal with borrowers through brokers and other intermediaries rather than having face-to-face relationships. "Lending is becoming more anonymous," says Rachel M. Dollar, a Santa Rosa, Calif., attorney... A lawsuit filed in December 2004 in federal court in New York by South Brooklyn Legal Services, a nonprofit law clinic, alleged that Argent Mortgage made a $425,000 loan arranged by participants in a foreclosure fraud scheme even though the application was incomplete and a title-insurance company warned the lender something was amiss with the deal... "The red flags were as strong as you can get," says Jessica Attie, a staff attorney with the clinic's Foreclosure Prevention Project. In court papers, Argent denied it was at fault in the case, which it settled in April.

The problem goes beyond brokers and the lack of face-to-face meetings. Banks now have dozens of branches, and the days of just a handful of bankers in any given town — a small group who could sense when something was wrong — are long gone. In today's market, companies originate mortgages, others purchase them from the originators, still others package them and even sell the principle and the interest separately. Title companies, home inspectors, credit bureaus, and others all play a part. Leaving aside the issues of moral culpability or legal culpability of the mortgage originators, the losses they will take in this case argue that it's time to look to how they manage the disaggregated pieces of their businesses.

Topics:  · finance · security

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