for securitized debt, replace ratings with data, statistical evaluations. Too rational? Not enough

[JohnWxy]

uncertainty to make a profit at the expense of the investors??


http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=103x536735


on edit: before people jump in, this of course will not remove ALL the uncertainty. NOthing could. But, it would remove some unnecessary uncertainties and improve the estimation of the risk involved in the investment. This would be a big improvement over the current way of doing things in the securitized debt world.

[Statistical]

1. That is all good once a pool of mortgages has data for statistically valid period of time.

However what do you do with new mortgages?

I bundle 100,000 mortgages with a face value of $200B into a pool. It is literally day 0 on repayment.

What is the likely default rate and please provide standard deviation so I have a useful range?

[JohnWxy]

2. known data already recorded on incomes and payment schedules would be loaded into the data-base from

Federal reserve data. There are data on these factors currently existing to which the data pertaining to your bundled mortgages would be compared. I didn't say, or didn't mean to imply that there would be no comparative aspect to the estimation of risk. Just that it could be done in more detail and with complete transparency. THe investor's software would compare the mortgages in a given CDO to historical data from very comparable loans already in the record and could come up with statistics ... based on historical performance data of loans matching (or very similar to the loans in the CDO).

Analytical results would be kicked out in summary form, showing how the factors contributing to the risk in the current CDO compared to historical data. Various statistical analyses could be performed.

Yes, the new CDO would not have any performance data on the loans in that CDO, but initial valuation would be based on comparing the static properties of your loans to historical performance data on loans with very similar properties's (payment amount related to monthly income, etc).

This would have the effect of making the CDO bundlers offer better products as investors would look for the best risk reward ratio and pay accordingly. MOre information, properly analysed, should 'tighten up' the building of each product. (that is, the bundler would thus be forced to put together a better balanced product as investors would avoid those CDOs which seemed to offer not enough pay-off relative to the risk inherent in the product.)

NOte that meaningful statistics on one sample can't be calculated unless compared to a meaningfully large set of base data .. which contain the full set of data on each of the loans... e.g. defaults over a meaningful period of time (most likely to maturity but it would depend upon the individual investor, I suppose).

[blue97keet]

3. Can somebody please explain why debt NEEDS to be securitized?

[notesdev]

4. It fills the important role

of allowing companies like Goldman Sachs to get a cut of the pie.

Seriously, though, the reason to securitize is that if the lenders can sell the loans, they'll be replenished with capital by doing so and can make new loans. Whether it is desireable for that to happen is a matter of debate.

The real sticking point is how these things are being represented to the buyers - many, many of these things got top ratings and turned out to be junk.

[jtuck004]

5. Well, let's say you are a bank, and sell mortgages.

You make a loan, and another, and another, and pretty soon you have a lot of loans out there, a lot of risk. So you sell them to someone and start over with some borrowed funds. The rate on that loan isn't that great, but you don't have so much risk. And if I sell it I need your permission. How unhandy.

But if instead I (as an investment bank)buy and break up those mortgages, (or student loans, or car loans, or whatever) into pieces I can create"structured asset-backed securities". Derivatives of these include credit default swaps - like insurance on a mortgage. By putting a little of this loan, and a little of that loan, and...say parts of 50 or so loans stuffed into a bunch of bonds, whose interest rates vary, I have created a new product, a bond with interest rates that vary. I then sell those bonds to someone to repackage, or hold them and buy insurance against the default (along with some other derivations). It was small business early in the 90's, but by the mid-90's they were really starting to pick up steam, cause you could start with $1 billion dollars, and soon have $40 billion. And as long as you kept the fund limited to a few investors, (very well-heeled ones, of course, there was no regulation).

(Now we are going to step away from your question of "why we need" to do this - cause the rest of this is just greed...)

And I or someone can buy those, and borrow the money to buy the insurance, say 30 or more times what the bond is worth because the requirements for the reserves I used to have to keep on hand were lowered, (thanks to my friends at the Federal Reserve, who used to work with people from my company or for people that work in the industry)...

And the company I can borrow from is now the bank I work for, (which is now across the hall because of the repeal of the last of the Glass-Steagall Act in 1999 thanks to my friends in Congress and lobbying by the Federal Reserve and the people at the Treasury that used to work for the company I work for) so I can use your bank deposits to fund my little game and sell the loans directly.

Part of the game is to buy insurance from companies like AIG in case it defaults - and get the rating agency, who is nearly sitting at the table at the close to rate the bond, and they rate the bond as AAA because if it defaults the bondholder gets paid first (they didn't really look to see if that the pieces were all sold as NINJA's (No income, no job, no assets) - they just noted that the mortgage had senior rights), and, hey, they get paid if it is rated so that you can sell it, right?

Done that way the terms you, the person who sold the original mortgage, can get are very favorable for money to make new loans. And the risk for default is spread across a lot of people, so no problem, eh?.

And did I mention that I have friends at the Federal Reserve? Because the Federal Reserve bailed out LTCM (Long Term Capital Management, a hedge fund) in August of 1998 I know that the government won't let us fail, so I sell these around the world, into pension funds, state governments, everywhere. In knots so thick we have no idea what is going on. (Think hairball). And my friends at other investment banks think it's such a great idea that they do it as well. (Did I mention I made a bundle by shorting the credit market, buying insurance on the holdings of LTCM, and made a bundle off of them? And when Greenspan and friends bailed out LTCM, they flooded the market with money to keep things rolling -and that just started a fire under my business and it went crazy).

Remember back early on in this I said we could "borrow" 30 times or more what the bond is worth? WAHOO - so now on some portion of the $13 trillion or so in mortgages in the U.S., my friends (hell,we play poker together - for BIG money) and I have created, roughly, $600 trillion worth of complex derivatives. We think. No one really knows.

Then that darn kid doesn't pay his mortgage. And his neighbor, and... well, I guess you know that by now the government has about $14 trillion set aside for our little spree? You didn't think it stopped with TARP in 2008, did you?. I mean, you could've just bought all the mortgages and put us out of business. It would have been rough on us (you see, we got $36 billion in bonuses in 2008), and you would have had to do business with all the small banks (We really snookered you people on that one) but thanks to our friends at the Fed and the Treasury we are still here, and our business is up 600% in 2010. (btw - your little finreg bill? We have a loophole because we are the end users, so you still won't be able to mess with us very much, and we will still operate behind the curtain you can't see behind. And we are still using your tax money).

That's not the good part - because no one can see what we do everyone blames it on the guy that believed the mortgage broker when he told him he could buy that $80K house for no money down on his minimum wage salary and make payments, even though he is feeding the kids with free lunches at school. No one can look behind our curtain and see that we have $2.4 million bet against him succeeding. And that's how we got to bet about $600 trillion.

Don't you just love math? ;) We do. That's why they call us Quants.

So thanks to CNN, and Fox, and even a bunch of people in Congress, and blogs all over the place, they all think it's that guys fault who just tried to buy a home for his wife and two kids.

Because it's all just too complicated for "you"...or at least that's what we were told.

-----------------------------------



Sorry, I got carried away. But that's what they did. You asked why debt "needs" to be securitized. It needs to be because they can get more capital at lower rates and spread the risk around. Which in 1990 is exactly how things were. But starting at Banker's Trust in New York, and then J.P. Morgan, and Deutsche Bank, math and physics majors, called Quants (short for Quantitative Analyst) took things to a whole new level, cause they figured out how to make big money from the risk. Which is not evil in and of itself, but what they built, and the unraveling of all that is why we have 30 million plus people unemployed or underemployed. And a very scary future.

When it gets to the hugely leveraged portion, they really don't NEED to do that, and it doesn't need to be opaque. But it lets the investment bank make a LOT more money.

Too complicated? Bull. Greed and irresponsibility is not complicated, and they should nerve have been allowed to use that excuse.

[econoclast]

6. Securitizing debt diversifies risk

Lots and lots of different kinds of debt get securitized. The basis impetus twofold. It keeps capital flowing from investors to borrowers and it helps diversify risk. Consider the basic security created from mortgage debt... The Ginnie Mae (gnma)
If I have money to invest and think that home mortgages are an attractive investment. I could simply look for someone who wants to buy a house and lend them the money. But all my eggs are in one basket. If the borrower defaults I'm screwed. Ok. I'd like to diversify risk. So I find some other like minded folks and we pool our money and make 100 loans. Now, if a few borrowers default, we are still OK. We are a mortgage bank. We had some money, we loaned it all out, we are done. Fine. But if there are still people who want loans what do we do? We could try to find new investors, but maybe those potential investors are a bit worried. All our borrowers are in the same neighborhood. Lots of them work for the local auto manufacturer. What if there is an earthquake/tornado/hurricane etc? What if the factory closes? So we are kinda' stuck.
Government steps in to help.
They create an agency that will buy our loans. They'll buy ours and those of other mortgage banks across the country. That agency will pool those mortgages into geographically diverse bundles. Those pooled mortgage bundles become the collateral that backs up a debt security. A GNMA. Investors are much more willing to buy these securities because the risks are geographically diverse. Plus, small investors can buy them. A small investor who only has 10,000 dollars can't make an individual mortgage loan. But they can buy a gnma.
So by selling the loans to gnma we get new money to lend to the borrowers we would otherwise be unable to lend to. And by gnma pooling those loans into securities backed by diverse bundles, investors get diversified risk. A win win.

That is the basic, bare bones logic of securitization. It gets WAAAYY more complicated. But that is the plain vanilla story.

[Statistical]

7. Generally speaking it adds liquidity and reduces the effect of single loan.

The problem isn't securitization the problem was the loans were crap.
Securitization didn't make the loans default. Had they been traditioanlly held the losses would have been the exact same amount.

The simple answer mortgages are large thus it is difficult to have a diversified pool of mortgages. Pretty easy to get diversified pool of stocks considering the low share price of each stock. Even bonds (usually $1K face value) can be diversified easily.

Not so easy with mortgages. Say average mortgage is $200K. To have no more than 1% in a single loan you would need $20 million. What if you only wanted to invest $10 million, or $5 million, or $100K?

The second issue is liquidity. Say you buy 100 mortgages but something happens and you need to sell some of them. Very difficult to price. Each house in unique. Repayment status matters, current valuation. While it can be done there is a lot of overhead (cost) to sell only a few loans.

Secularization solves both problems. First a pool of loans is bought. Say $100 million in loans. Then it is broken into pieces (kinda like shares in a company). Say 1000 pieces each representing 0.1% of the pool for $100K each.

You can invest any amount from $100K up to $20 million. You have diversity in loans (owning a piece of 500 loans instead of single loan). Also if/when you need to sell the loans you can do so with more liquidity. If you like the pool you can reinvest income from security to buy more "shares".

[jmowreader]

9. I believe securitization was one of the reasons the loans were made

Because the loans are going to be sold, the risk is transferred away from the bank. Hence, it encourages mortgage companies (I'd be willing to bet that most of those shit loans were originated at little mortgage companies rather than banks) to go looking for mortgages that offer high fees rather than low-risk ones you know are going to be paid off.

The one-two punch of builders not building starter homes anymore and house flippers forcing up the price of existing homes has a lot to do with it too--quite a few of the people who "couldn't afford a house" could have afforded one easily if the whole market didn't start in the $180s.

[Po_d Mainiac]

8. Because Americans don't have savings..And that which they do have

Is loaded into the Casino Wall St's slot machines, not their local thrift or CU.