Prosper Adds Portfolio Plans

Prosper has added a way to create a portfolio of loans targeting a certain risk level. Flavors include Conservative  (target 8.55%), Balanced (9.20%), Moderate (10.40%) and Aggressive (11.56%).  They work by creating standing orders for certain loans based on specified criteria.  You can also create your own portfolio of standing orders to create a customized portfolio.  Obviously taking a page from the Zopa UK handbook, but a good addition overall that highlights the versatility of the platform.


Zopa US – Worth the Wait?

I’m tardy in posting on Zopa US. In a nut shell, their system here works in the following way:

  1. You buy a CD from a credit union, which you have to join.
  2. I take an unsecured personal loan from the credit union, which I have to join.
  3. If you like me or my project you can contribute interest from your CD to reducing my interest payment.
  4. Zopa earns fees originating loans and servicing them.  Do they also earn a fee for each new credit union member?
  5. The credit union earns the spread between the CDs  and the rate on the unsecured personal loan.
  6. The credit union takes the risk of loss.
  7. Presumably the credit union offers both of us additional products making this potentially a lower cost member acquisition channel for them.
  8. To the extent that CD’s exceed underwritten loans, the credit unions have a new source of deposits.

I like the participation of the credit unions and the potentially viral nature of getting family and friends to subsidize a loan, but I think we’ll have to wait and see how Zopa and the credit unions extend the platform before we really know the potential of the model.

The Pain of Correlation

Good article from the WSJ (subscription) on how some CDO’s went bad along with why risk became concentrated.  Includes a nice graphic that explains how CDOs work.  From the article:

the system works only if the securities in the CDO are uncorrelated — that is, if they are unlikely to go bad all at once. Corporate bonds, for example, tend to have low correlation because the companies that issue them operate in different industries, which typically don’t get into trouble simultaneously.

Mortgage securities, by contrast, have turned out to be very similar to one another. They’re all linked to thousands of loans across the U.S. Anything big enough to trigger defaults on a large portion of those loans — like falling home prices across the country — is likely to affect the bonds in a CDO as well. That’s particularly true for the kinds of securities on which mezzanine CDOs made their bets. Triple-B-rated bonds would typically stand to suffer if losses to defaults on the underlying pools of loans reached about 10%.

A Modest Proposal to Restart the Mortgage Securitization Market

The securitization market for mortgages has effectively ground to a halt. The reason that Citi and Merrill have revised their estimates of losses so shortly after announcing previous numbers is simple. The commonly shared assumptions about how to value these securities have evaporated. This means that instead of using a trading price to value their assets (known as marking-to-market) investors must use complex valuation models to determine the book value of the securities they are holding (known as marking-to-model).

Without the anchoring of market prices, each holder of the same assets must make their own assumptions about how to value their holdings when marking-to-model. In the current environment, there is significant pressure to use more conservative assumptions than those that were used just a few weeks ago, resulting in steep reductions in value and the large write-offs we’ve seen.

Obviously increasing default rates and uncertainty about home prices is a significant element, but an important part of the problem is the nature of these securities. A subprime securitization consists of a pool of mortgages. The monthly payments from that pool of mortgages is combined and the cash is then distributed according to a complex set of rules to security holders. As a simplified example, if you had a pool of 1,000 mortgages each with a monthly payment of $2,000 then the monthly cash available to the security holders is $2,000,000. That cash of course consists of both interest and principal. The principal payments go off to repay principal on some of the securities while interest payments go off to pay interest on some of the securities. Sometimes those overlap, sometimes they don’t.

So what’s the root of the problem right now? First, none of the security holders know who the mortgage holders are. So they can’t truly evaluate the risk of each mortgage in the pool and thereby the total risk of default of the mortgages themselves. Second, the rules that govern the cash flow of the securities are very difficult to understand in themselves. That’s why the credit ratings of the securities have been so important. If Moody’s or S&P said the security was AAA that was like saying you had something nearly as safe as US Treasury Bonds. Unfortunately, confidence has fallen steeply in the ability of the rating agencies to accurately evaluate the risk of these securitizations.

Now let’s add one more complication that makes things even harder to resolve. Investment banks bought securities backed by various pools of mortgages and combined those securities to create yet new financial instruments. These are called collateralized debt obligations or CDOs. Think of it as someone going into a pastry shop and buying a slice of chocolate cake, a slice of lemon meringue, half an oatmeal cookie and an eclair then mashing them up and selling the result as a new dessert. The problem is you can’t very easily figure out the flavor of this concoction. This is what makes CDOs even harder to value than regular securitizations. It’s tough to determine exactly what they are since you don’t have much insight into the underlying assets. And there are even CDOs made up of slices of other CDOs which are even harder to figure out.

So what’s a potential way to resolve the current situation? The first step is to create transparency in the market through an impartial third party. This third party would identify all of the mortgage holders in each securitization pool. They would then assess the risk of default for each of those mortgage holders and create an overall expected default rate. They would do this without revealing the identity of the underlying mortgage holders to maintain privacy.

The third party would then use the rolled up default estimate along with other clearly stated assumptions to value each tranche of each securitization to create a reference valuation. This would involve taking into consideration the complex rules that govern the distribution of principal and interest from the pool of mortgages. This third party would then use the securitization reference valuations to go through the same process for CDOs.

All of this must be done as transparently as possible so that investors can understand exactly how to adjust the reference valuation for their own particular views. The important point is that this mechanism would re-establish a point from which the market could once again build a consensus around the fair value of these securities. This would also provide investors with a widely known data point for marking-to-model.

Clearly there are a number of challenges to this proposal, but each is surmountable. Given the magnitude of this crisis, the health of the economy depends on the market re-opening.

Wall Street to Invest Heavily in Risk Analytics, But the Fat Tail Remains

From Wall Street & Technology, a short article on one of the big focuses for Wall Street IT spending in 2008, risk management systems.

From the article:

Integrating data and risk practices across a financial institution is pricey and difficult, especially in “Wall Street” time, where things are measured quarter to quarter. However, the price tag for even the most complex data and risk management integration at the largest financial institution will pale in comparison to the billions that have been lost due to inaccurate CDO calculations.

While the article makes sense overall, the idea that billions have been lost on “inaccurate” CDO calculations is not entirely accurate.  I’m sure that happened in some cases, but these models are driven by assumptions and there is still risk from the fat tail.  The current housing default rates were simply not seen as even remotely probable when the subprime securitizations were structured.

Accident Insurance by Text Message

I came across Cover2go’s South African micro-insurance product this afternoon after seeing the write-up at The summary:

One SMS to 38858 gives you instant accidental death cover – no visits to brokers, no medical tests, and no forms. A once-off charge of R 10 [US$1.43], from your airtime, gives you a full 30 day accidental death cover to the value of R 15 000 [US$2,143].

This is not life insurance and only covers accidents, but it appears to be offered at a reasonable rate through an incredibly low cost distribution channel.

From the write-up:

“Every day, a large majority of South Africans have to board minibus taxis, many of which are notoriously unsafe. For people travelling over the most dangerous periods such as the Easter weekend, the risk to the wellbeing of their families is very real – 276 people died this past Easter holiday. Unfortunately, the common perception is that life assurance is a luxury that’s unaffordable and complicated to obtain. With Cover2go, people can get basic cover instantly, at very affordable prices, when they need it most,” says Derek Pead, CEO of Cover2go, a division of Metropolitan Life.

This is the process of signing up:

  1. SMS your name and date of birth (ddmmyyyy) to 38858
  2. You will then get an SMS back with your policy number
  3. Tell the beneficiary who will receive the money in the case of your accidental death that you have the policy. Cover2go will pay out a claim to beneficiaries in the following order: your spouse or life partner, your children, your parents, or your Estate. At claims stage we will ensure that the correct person gets the money. It’s best to let the beneficiary know that you have the policy, so that they know to contact us to claim.
  4. Also tell them about the Claim Line: 0860 COVER2GO (0860 2683 7246)

The product is being offered by Metropolitan. The company description from Hoovers:

Metropolitan takes a decidedly national approach to insurance and financial services. Born in 1898, the company is one of the largest financial services conglomerates in South Africa serving the lower- and middle-income markets. Metropolitan provides life insurance to some 4.3 million residents, making it the country’s fourth largest life insurer. Its life products are distributed directly and through preferred intermediaries, direct marketing, brokers, and via voluntary group schemes. Metropolitan additionally offers retirement fund benefits, acts as asset manager, and supplies medical aid and managed health-care administration.

Verizon Opening Network

Big news.  Verizon wireless will open its network to any device or application that meets its minimum requirements.  Look for a new wave of early stage venture funding into mobile apps and devices.