Does Debt Due Diligence Scale Well Enough?

I've often made the point that we will only curb excessive fees and risk-taking in the financial markets by vastly simplifying products and making them more broadly accessible. In debt terms, think of this as the 'flat' distribution of risk - or parcelling each loan amount into tiny loans at inception, like at Zopa - rather than the hierarchical or vertical distribution of risk in today's bond markets - where a series of separate loans is packaged into 'tranches' that a bank and credit rating agency estimate will perform similarly, and bonds are issued (and derivatives concocted) according to the varying grades of likely default risk.

The critical potential downside to hierarchical risk distribution is being illustrated by the ongoing 'fraudclosure' and 'forced repurchase' problems in the US mortgage-backed securities market. A root cause may be that due diligence on the scale at which loans must be packaged to fuel the existing bond markets may not scale well enough to provide adequate risk estimates, particularly when the loans have a short history or there is a lengthy chain of loan ownership or loan servicing obligations. Of course, we have a similar challenge on a grander scale in the market for credit default swaps and collateralised debt obligations. But that's a layer above where the current problems are occuring.

The 'fraudclosure' problem arises from allegations in a large number of cases that subsequent loan-owners have not satisfied the formal requirements involved in foreclosing on problem loans. JP Morgan analysts reportedly believe that delays in foreclosures while the technical issues are addressed "will damage senior-ranked non-agency mortgage securities, costing as much as 4 cents on the dollar for certain bonds if postponements take six months."

The 'forced repurchase' saga centres on allegations that certain loans that were sold did not meet underwriting or appraisal standards under the relevant debt sale agreements. The same JPMorgan analysts reportedly believe the banks' losses from repurchases of such loans "will likely total $55 billion to $120 billion, or potentially $10 billion to $25 billion for the next five years."

The fact that these risks have gone unnoticed on this scale until recently suggests a substantial flaw in the due diligence methodology employed in the securitisation and/or subsequent 'collateralisation' process. And one wonders whether any different methodology has since been used by those reporting on whether or not they have an issue amongst their existing holdings, and the scale of any such issue. The explanation of one methodology allegedly used by an anonymous 'whistleblower' to package loans into bonds, was published today by Zero Hedge, and makes interesting reading. In short, the person says:

"...we worked with underwriters of the deal to perform due diligence. That is where this process breaks down. They use sampling to verify the makeup of the pools. There is a lot of pressure to get the deals done in a timely manner so they don’t have time to check every asset. The most I’ve ever checked on a deal is 30%. We’ve done some pools that came back very different from what the trader originally told us.

...

Don’t get me wrong, I’m not saying that all deals are incorrect, most aren’t. I’m saying that many are, and we have no way of knowing which deals are tainted. Fortunately, most deals have been seasoned a bit which make them easier to value, but the foreclosure documentation is just one instance where my shady scepticism has been vindicated. I knew there was shit floating around in the pools we were putting together, but the sampling technique and level of due diligence was never going to clean it out."

In other words, the scale of bond issuance, pressure of time and the cost of 'full' due diligence seem to encourage costly short-cuts which generate hugely uncertain outcomes.

But this seems to be far less of a problem where loans are appraised and parcelled out at inception according to transparent underwriting standards. Lenders' experience at Zopa is instructive here. But I would say that, wouldn't I? Funding Circle and the Receivables Exchange are examples in the small business finance space, as is the idea of reverse invoice discounting.

Greed Is Still Good

If you don't want to know the ending to the film Money Never Sleeps, stop reading now.

For the rest, I have to say I'm troubled by whether audiences believe the ending to this movie is a positive "Hollywood" resolution, instead of the grimly ironic testament to persistent greed that it actually is.

To cut the story short, Gordon Gecko, immortalised by the line "Greed...is good", leaves jail after doing time for crimes committed during Wall Street, only to trick his 'leftist' daughter and her naïve fiancé into returning $100 million of the ill-gotten gains Gordon had salted away in his daughter's name. She'd been going to give it to charity, but her fiancé convinced her to invest it via him and Gordon in a 'clean-tech' alternative energy company (the nature of whose connection with the fiancé is never satisfactorily explained). Gordon somehow diverts the cash, ruining their plans and their relationship in one hit. As a result, he's told he'll never see his grandson-to-be, which seems to be the only thing in the world that really bothers Gordon. In the final scene, however, Gordon is redeemed in the eyes of his daughter and her fiancé - and heals the emotional rift between them - by dropping by to announce that he's deposited a freshly laundered $100 million in the bank account of said energy company. Gordon can now spare the cash, he happily explains, because he's just made another fortune shorting the markets and managed to skim a little cream for himself via the Cayman Islands. Cue the wedding and dancing.

I guess one can't blame a daughter for wanting her dear old dad to be around her child, even if he is only anxious to teach the kid the equivalent of safe-cracking. But I was struck by the fact that she's also billed as a 'leftist' and that she and her fiancé share a passion for 'clean-tech' alternative energy. And I reckon the example of their easy forgiveness in the film might be a sign that audiences think that the Bernie Madoffs of this world - indeed our financial institutions - can redeem themselves simply by investing their ill-gotten gains in 'worthy causes' - or by repaying their bailout money - rather than by behaving ethically.

Or, in other words, that greed is still good.

This is chilling enough when you consider that such a view would endorse the illegality, or at least the immorality, of the mortgage brokers and bankers who gleefully shoveled the likes of NINJA loans into the bond markets and even simultaneously shorted the resulting bonds - all at the taxpayers' expense. But it's especially chilling given the recent sober reminder from Hank Paulson, formerly both Chairman/CEO of Goldman Sachs and US Treasury Secretary at the start of the financial meltdown (somewhat simultaneously, some seem to be suggesting):

"Speaking close to the two-year anniversary of Lehman Brothers' collapse, Mr Paulson said that while he welcomed much of the new financial regulation, it would not be enough to prevent another crisis. "We have to assume that regulation won't be perfect. We'll have another financial crisis sometime in the next 10 years because we always do.""

Timely, too, that UBS, the global investment bank, should announce today that it won't be pursuing the former senior managers who appear to have put in place “incentives...to generate revenues without taking appropriate consideration of the risks [that]...facilitated losses” because any such court action would be “more than uncertain”, expensive and “lead to negative international publicity and thus hamper UBS’s efforts to restore its good name in the markets” [my emphasis]. What's that a 'good name' for, exactly? And what sort of message does that meek surrender send to the current management, clients and other stakeholders?

Why, that greed is still good, of course.

Paulson, perhaps ironically, is right. No amount of regulation will change this cultural belief. It's a crisis of leadership, yes, but only because we get the leadership we deserve. Cultural change is something that must evolve bottom-up.

And that's what troubles me about the forgiveness, wedding and dancing at the end of Money Never Sleeps. If Hollywood had been confident that our values had changed, the only thing that would have united the young lovers would have been a strenuous and simultaneous citizens' arrest.

Of Exhaust Pipes, Tyres And Social Lending

I was lucky enough to be invited to Tuesday night's Financial Services Club talk by Giles Andrews, CEO of Zopa. It was a real treat to hear an update on progress at the 'old firm', especially when Giles showed the unmistakable 'hockey stick' inflection point in the £100m of social lending on Zopa since March '05. Zopa estimates that its members have cornered a 1% share of the personal loan segment of the UK lending market, but with an average default rate of 0.7%.

In an intriguingly fresh take on the social lending phenomenon, Giles explained that savings and loans are in the same class of vulnerable, cosy-little-profit-centre for retail banks that exhaust pipes and tyres once occupied for car dealerships before Kwikfit came along. And just as Kwikfit's focus on price and convenience enabled it to steal an unassailable march on the incumbents in the car servicing market, Giles estimates that in another 5 years Zopa members could easily achieve a 10% share of the personal loan segment of the UK lending market - and people's participation in social lending of all forms could account for half of all UK personal loans.

Given everything else likely to be going on in the retail banking market over the next 5 years, I guess banks could be forgiven for leaving a little more money on the table for the rest of us.

Of course, economically, the reality of social lending is starkly different from the cosy-little-retail-bank-profit-centre represented by traditional savings and loans. Individual lenders and borrowers divide most of the 'spread' between social lending and borrowing rates, not Zopa itself - and certainly not retail banks.

In addition to the economics, Giles believes that transparency is a key driver of Zopa's success. That's not an empty statement, given that members set their own terms and seasoned Zopa members moderate their discussion boards rather than Zopa staff. Zopa also encourages members to use Twitter for informal requests, queries or non-sensitive admin, because it's faster and more accessible, efficient and transparent than email or spending ages holding on the phone or visiting a physical branch.

With these competitive advantages, social lending is definitely here to stay.

Here is Chris Skinner's in depth report on the evening.

That Government Waste Report In Full

Isn't it annoying that the 'news' media 'report' on the results of research, but never provide a link to the source? Well, here's the link to "Efficiency Review by Sir Phillip Green", without any link to media reports. So there.

It's only 33 slides, and I urge every taxpayer to take it in.

My 'takeaways' are that nobody knows enough about how the public sector spends our money to ensure we get real value for it. So we don't even know how much money could be 'saved' by finding out. But Sir Phillip's best guess is that getting a handle on it all will be very worthwhile in terms of policemen, teachers and other essential front-line public services, if not outright spending cuts.

I hope they get on with it. Fast.

Gen Y: Rise of The Pragmatists

On Wednesday I attended the launch of The Faith of Generation Y by Sylvia Collins-Mayo, Bob Mayo and Sally Nash, which the Daily Telegraph responded to on its front page on Monday.

Bob and Sylvie are friends (well of course, but also friends of mine), so this is a bit of a plug.

But in the course of the co-authors' presentation of some key findings, one of many interesting observations struck me in particular. Bob explained that Generation Y people are not so reactive to organised religion as their elders in Generation X, who tended to have had it forced on them as kids. Instead, Gen Y'ers are just as interested to hear what religion is and what it stands for, as any of the other spiritual messages out there. However, they aren't interested in whether the message represents the 'truth' in some dogmatic sense, but pragmatically whether it 'works'. So you will find a Gen Y person chilling out in a church because it is a chilled, spiritual place to be, rather than because he 'believes'.

Bob says this attitude is also encouraged by Gen X people as parents (and teachers?), who tend to be friends with their kids and tolerant or permissive of independence, critical thought and discussion, rather than more authoritarian or controlling as their own parents' generation tended to be.

I suspect this has at least two broad implications for all of our society's public and private institutions. First, while other research shows there has been a decline to low levels of trust in our institutions, this may be driven by and limited to Gen X'ers, as a result of the previous generations' tendency to trust in or tolerate institutions, regardless of how badly they perform. Secondly, Gen Y may be free of the emotionally reactive element of Gen X's attitude to institutions, but very focused on what those institutions stand for - what they promise - and whether those institutions 'work' or perform accordingly.

So if you thought the internet and Web 2.0 marked a revolution in personalisation, you ain't seen nothing yet.