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I work in finance and there has been a lot of interest recently in creating financial products that are eerily like mortgage backed securities, but for other ty

I work in finance and there has been a lot of interest recently in creating financial products that are eerily like mortgage backed securities, but for other types of loans. A lot of these are (yikes) unsecured loans. A person loses their job and needs a personal loan from a bank or credit union to cover their expenses until they find a job. A person buys a car, an RV, etc. In order to offload the risk of these loans, the original lender is packaging them up together. Then they can sell ownership of the consolidated loans to other financial institutions. The original lender is only required to retain around 10% of the consolidated loans. Needless to say, the institution originating the loan ends up disconnected from the risk once it is sold to other financial institutions. At least they're insured, right?

x2f10 7y ago
>Needless to say, the institution originating the loan ends up disconnected from the risk once it is sold to other financial institutions. In many cases, isn't this already the case with the largest consumer loans (mortgages)? If the buyer understands the risks of the consolidated loans, what's the beef? If the bank is hiding the risks, that's another issue - I agree.
- robmiller 7y ago
  The house is the collateral in a mortgage though.
  - suff 7y ago
    The very-very upside-down house...
    - toomuchtodo 7y ago
      Which you have the privilege of holding onto for years after a 12-24 month foreclosure process. “Collateral”.
- gibybo 7y ago
  >If the bank is hiding the risks, that's another issue - I agree. I think the point is that this creates a lot of incentive for the bank to hide the risks that they wouldn't otherwise have. Perhaps more importantly, it doesn't incentive them to prioritize things that might help them measure the risk better, so those sorts of improvements never get made and it just deteriorates over time.
- logicalmind 7y ago
  The loan originator has a different risk calculation when their ultimate intent is to offload 90% of the loan(s). Some might say it would be in their own financial interest to minimize the amount of due diligence involved in determining whether to give such loans. Plausible deniability. From a buyer's perspective, they receive the due diligence that the originator provided. There are various risk models put in place with that information, but they are also "insured". These are the same fundamentals that led to the 2008 crisis. Giving loans to people who weren't actually qualified. Miscalculating the risk, intentionally or not. Buyers ok with the risk, assuming the insurance would come through in the worst case. If there is an event, or a series of events, that cause these loan takes to become insolvent, say losing jobs with no hope of getting a new one (truck drivers being replaced with self-driving trucks?), that would cause large amount of loan defaults...
  - cm2187 7y ago
    Except the 90% is not a vertical slice, it is horizontal. I.e, the first 10% of notional in losses on the whole portfolio goes back to the originator. The profit on the transaction would have to be huge for this not to realign the incentives.
deleted 7y ago
[deleted]
ancorevard 7y ago
"The original lender is only required to retain around 10% of the consolidated loans." That part may be the only redeemable part of this process. Because, hey...let's package these into collateral debt obligations, and then hey...let's engineer these CDOs with tranches of various credit quality as rated by rating organizations not understanding what they are rating and afraid of asking for more information because their profit is based on volume of these ratings and not quality, and hey...let's create a second CDO based on the lowest rated tranche of the first CDO, and boom, that low credit score is magically now a AAA, and why not create tranches of this second CDO too. Then, let's create a market out of this with a way to short the CDOs, and let's call this new instrument something ridiculous as Credit Default Swap. No one is ever going to need those, because everybody in the financial industry believes the underlying assumptions that 1) the real-estate prices will forever go up, 2) and there is no chance that more than 4% of sub-prime mortgages are going to default. Seeing that this makes a lot of sense, let's make a trillion dollars worth of these and we don't have to put them on the balance sheet because they are AAA rated, safe as the US Treasury bonds, and so why not get leveraged 40 to 1 on these. Oh wait, that's already been tried.
- logicalmind 7y ago
  Yep, it is the same thing over again with a different underlying loan source. And why shouldn't it be. The people responsible for the 2008 crisis are mostly still in place. In fact, many of the people who survived were promoted to more prominent positions. In fact, some say the loans of 2008 are said to be "recovering" and it's "not so bad". This translates from the expectation that these loans would lose 90% of their value and they ended up only losing 75%.
  - neffy 7y ago
    Exactly. And 10 years after the crash - the fact that the first paragraph of this article is factually wrong (thereby illustrating a lot of what is still wrong with macro-economic analysis) - goes unremarked. Banks do not lend their deposits. (That's what a fund does.) Banks create deposit money when they make a loan, and statistically multiplex asset cash against deposits to manage transfers of money within the banking system. Repayment of loans then removes the created deposit money from the system.
nerdponx 7y ago
What's the incentive to buy such a toxic bundle?
- lisper 7y ago
  High returns at low risk (as long as you believe the rating agencies).
  - raxxorrax 7y ago
    The risk is always pretty low if you can leverage taxes for the worst case.
  - nerdponx 7y ago
    Why would the agency rate it as low-risk though? Because they are assuming that individual defaults are uncorrelated? The variance of the distribution of returns of a portfolio like that must be huge, not to mention the risk of an economic downturn putting the entire portfolio into default. I'm just an armchair analyst, but I'd love to know what the people buying these loan packages know. Because it doesn't seem low risk to me.
Mirioron 7y ago
Isn't it the job of Credit Rating Agencies to give poor ratings to these packages if the loans in them are bad?
- cm2187 7y ago
  What makes you think they don’t? Rating agencies have been burned by the last crisis and are poised not to make the same mistakes.
  - icebraining 7y ago
    Is there a /s I'm missing? What evidence is there that they are doing anything differently, and what incentive would they have to do so?
    - cm2187 7y ago
      What evidence do you have? I work with the teams who structure these transactions and get them rated on the bank side. Their methodologies have been revised, every communication with the originating bank is recorded and actively monitored (they have a compliance officer on every call), they do not allow feedback or revising their initial rating to optimise the structure. They have become paranoid. What makes you think they are not? And their incentive is the same as an audit company, it is an existential threat.
      - saiya-jin 7y ago
        I don't think you understand how trust works. Rating agencies have failed so many times, with bad consequences mainly for common folks instead of higher management (I mean long prison terms for whole C-suite/senior mgmt + all personal assets lost) that they need to bring some seriously good performance, over long time (say at least 2 economy cycles) to gain back at least some portion of trust. Sharp suites and clever talk only won't impress anyone anymore.
      - icebraining 7y ago
        > What evidence do you have? The business model is the same; big failures are still common (e.g. the recent case of Oi SA); the same Big Three still control the market; "no meaningful reform of the credit-rating agencies has been undertaken" (Paul Volcker). > And their incentive is the same as an audit company, it is an existential threat. What existential threat? Which relevant (and this mostly means the Big Three, which "issued 97%–98% of all credit ratings in the United States and roughly 95% worldwide") rating agency has went bankrupt or even faced a major threat to its dominance?
JTbane 7y ago
How long until these unsecured loans go bust and the big banks beg for a bailout again?
- dd36 7y ago
  When the next recession comes.
cm2187 7y ago
Well the 10% is I assume an equity tranche. Ie any loss on any loan in the portfolio goes to that tranche first up until the total losses exceed 10%. So the bank still has significant skin in the game, unless their short term profit exceeds 10%, which seems kind of high to me (but I don’t know the terms of the transaction you refer to).
deleted 7y ago
[deleted]
kchoudhu 7y ago
Asset backed securities aren't really new: funnily enough, the same models that are used to price and work with mortgage backed securities can be rapidly hacked to work for credit card debt, mobile homes and well, pretty much anything else out there. Someone's buying it, so the banks are making the sausage again. Such is life.
netcan 7y ago
The whole issue is so grey, that it'll be hard to find a robust solution to it, without some sort of wholesale change. There is a lot of overall sense in having retailers focus on retailing, and leave the high finance stuff to underwriters, like insurance. The problems is that the laissez faire market dynamics degenerate at this point, Retailers get too good at retailing, selling people bad deals that could land them in trouble later. Underwriters focus on securitization, which is ultimately a sister to the money-creation process (like "fractional reserve" banking). Pretty much any solution is clunky. You can try to force "originators" to hold risk, but this limits scale. You can regulate underwriting rules (affordability & doc checking standards, for instance). You can regulate underwriting, but the high finance sector is (a) good at influencing regulators and (b) good at finding ways around regulations. |regulating for risk is a tricky business. You end up trying to regulate away risk, which is impossible.
fredgrott 7y ago
no they are not inf act disconnected as 2008 disaster showed with those saqme banks buying insurance on such new finance dreviatives

x2f10 7y ago

>Needless to say, the institution originating the loan ends up disconnected from the risk once it is sold to other financial institutions. In many cases, isn't this already the case with the largest consumer loans (mortgages)? If the buyer understands the risks of the consolidated loans, what's the beef? If the bank is hiding the risks, that's another issue - I agree.

robmiller 7y ago
The house is the collateral in a mortgage though.
- suff 7y ago
  The very-very upside-down house...
  - toomuchtodo 7y ago
    Which you have the privilege of holding onto for years after a 12-24 month foreclosure process. “Collateral”.
gibybo 7y ago
>If the bank is hiding the risks, that's another issue - I agree. I think the point is that this creates a lot of incentive for the bank to hide the risks that they wouldn't otherwise have. Perhaps more importantly, it doesn't incentive them to prioritize things that might help them measure the risk better, so those sorts of improvements never get made and it just deteriorates over time.
logicalmind 7y ago
The loan originator has a different risk calculation when their ultimate intent is to offload 90% of the loan(s). Some might say it would be in their own financial interest to minimize the amount of due diligence involved in determining whether to give such loans. Plausible deniability. From a buyer's perspective, they receive the due diligence that the originator provided. There are various risk models put in place with that information, but they are also "insured". These are the same fundamentals that led to the 2008 crisis. Giving loans to people who weren't actually qualified. Miscalculating the risk, intentionally or not. Buyers ok with the risk, assuming the insurance would come through in the worst case. If there is an event, or a series of events, that cause these loan takes to become insolvent, say losing jobs with no hope of getting a new one (truck drivers being replaced with self-driving trucks?), that would cause large amount of loan defaults...
- cm2187 7y ago
  Except the 90% is not a vertical slice, it is horizontal. I.e, the first 10% of notional in losses on the whole portfolio goes back to the originator. The profit on the transaction would have to be huge for this not to realign the incentives.

deleted 7y ago

[deleted]

ancorevard 7y ago

"The original lender is only required to retain around 10% of the consolidated loans." That part may be the only redeemable part of this process. Because, hey...let's package these into collateral debt obligations, and then hey...let's engineer these CDOs with tranches of various credit quality as rated by rating organizations not understanding what they are rating and afraid of asking for more information because their profit is based on volume of these ratings and not quality, and hey...let's create a second CDO based on the lowest rated tranche of the first CDO, and boom, that low credit score is magically now a AAA, and why not create tranches of this second CDO too. Then, let's create a market out of this with a way to short the CDOs, and let's call this new instrument something ridiculous as Credit Default Swap. No one is ever going to need those, because everybody in the financial industry believes the underlying assumptions that 1) the real-estate prices will forever go up, 2) and there is no chance that more than 4% of sub-prime mortgages are going to default. Seeing that this makes a lot of sense, let's make a trillion dollars worth of these and we don't have to put them on the balance sheet because they are AAA rated, safe as the US Treasury bonds, and so why not get leveraged 40 to 1 on these. Oh wait, that's already been tried.

logicalmind 7y ago
Yep, it is the same thing over again with a different underlying loan source. And why shouldn't it be. The people responsible for the 2008 crisis are mostly still in place. In fact, many of the people who survived were promoted to more prominent positions. In fact, some say the loans of 2008 are said to be "recovering" and it's "not so bad". This translates from the expectation that these loans would lose 90% of their value and they ended up only losing 75%.
- neffy 7y ago
  Exactly. And 10 years after the crash - the fact that the first paragraph of this article is factually wrong (thereby illustrating a lot of what is still wrong with macro-economic analysis) - goes unremarked. Banks do not lend their deposits. (That's what a fund does.) Banks create deposit money when they make a loan, and statistically multiplex asset cash against deposits to manage transfers of money within the banking system. Repayment of loans then removes the created deposit money from the system.

nerdponx 7y ago

What's the incentive to buy such a toxic bundle?

lisper 7y ago
High returns at low risk (as long as you believe the rating agencies).
- raxxorrax 7y ago
  The risk is always pretty low if you can leverage taxes for the worst case.
- nerdponx 7y ago
  Why would the agency rate it as low-risk though? Because they are assuming that individual defaults are uncorrelated? The variance of the distribution of returns of a portfolio like that must be huge, not to mention the risk of an economic downturn putting the entire portfolio into default. I'm just an armchair analyst, but I'd love to know what the people buying these loan packages know. Because it doesn't seem low risk to me.

Mirioron 7y ago

Isn't it the job of Credit Rating Agencies to give poor ratings to these packages if the loans in them are bad?

cm2187 7y ago
What makes you think they don’t? Rating agencies have been burned by the last crisis and are poised not to make the same mistakes.
- icebraining 7y ago
  Is there a /s I'm missing? What evidence is there that they are doing anything differently, and what incentive would they have to do so?
  - cm2187 7y ago
    What evidence do you have? I work with the teams who structure these transactions and get them rated on the bank side. Their methodologies have been revised, every communication with the originating bank is recorded and actively monitored (they have a compliance officer on every call), they do not allow feedback or revising their initial rating to optimise the structure. They have become paranoid. What makes you think they are not? And their incentive is the same as an audit company, it is an existential threat.
    - saiya-jin 7y ago
      I don't think you understand how trust works. Rating agencies have failed so many times, with bad consequences mainly for common folks instead of higher management (I mean long prison terms for whole C-suite/senior mgmt + all personal assets lost) that they need to bring some seriously good performance, over long time (say at least 2 economy cycles) to gain back at least some portion of trust. Sharp suites and clever talk only won't impress anyone anymore.
    - icebraining 7y ago
      > What evidence do you have? The business model is the same; big failures are still common (e.g. the recent case of Oi SA); the same Big Three still control the market; "no meaningful reform of the credit-rating agencies has been undertaken" (Paul Volcker). > And their incentive is the same as an audit company, it is an existential threat. What existential threat? Which relevant (and this mostly means the Big Three, which "issued 97%–98% of all credit ratings in the United States and roughly 95% worldwide") rating agency has went bankrupt or even faced a major threat to its dominance?

JTbane 7y ago

How long until these unsecured loans go bust and the big banks beg for a bailout again?

dd36 7y ago
When the next recession comes.

cm2187 7y ago

Well the 10% is I assume an equity tranche. Ie any loss on any loan in the portfolio goes to that tranche first up until the total losses exceed 10%. So the bank still has significant skin in the game, unless their short term profit exceeds 10%, which seems kind of high to me (but I don’t know the terms of the transaction you refer to).

deleted 7y ago

[deleted]

kchoudhu 7y ago

Asset backed securities aren't really new: funnily enough, the same models that are used to price and work with mortgage backed securities can be rapidly hacked to work for credit card debt, mobile homes and well, pretty much anything else out there. Someone's buying it, so the banks are making the sausage again. Such is life.

netcan 7y ago

The whole issue is so grey, that it'll be hard to find a robust solution to it, without some sort of wholesale change. There is a lot of overall sense in having retailers focus on retailing, and leave the high finance stuff to underwriters, like insurance. The problems is that the laissez faire market dynamics degenerate at this point, Retailers get too good at retailing, selling people bad deals that could land them in trouble later. Underwriters focus on securitization, which is ultimately a sister to the money-creation process (like "fractional reserve" banking). Pretty much any solution is clunky. You can try to force "originators" to hold risk, but this limits scale. You can regulate underwriting rules (affordability & doc checking standards, for instance). You can regulate underwriting, but the high finance sector is (a) good at influencing regulators and (b) good at finding ways around regulations. |regulating for risk is a tricky business. You end up trying to regulate away risk, which is impossible.

fredgrott 7y ago

no they are not inf act disconnected as 2008 disaster showed with those saqme banks buying insurance on such new finance dreviatives