The Bankwatch

Tracking the consumer evolution of financial services

The need for genuine transparency in security risk assessment | peer-to-peer lending as an alternative

This little nugget from Gillian Tett at the Financial Times last week brought a few thoughts into sharp focus.

Is this the lull before the storm for US mortgages?  |

For this spring, something of a paradox is hanging over the mortgage-backed securities world. At the end of this month, the US Federal Reserve is due to freeze its programme to purchase Fannie and Freddie agency MBS that it implemented in the wake of the financial crisis.

However, before anyone is tempted to crack open the champagne, they should think – once again – about that “displacement” effect. During the past two years, the full impact of the collapse of the securitisation market has been largely concealed from most investors – let alone American politicians – because of the sheer scale of government assistance on offer. In a sense, investors have been lulled into something of a false sense of security, because so much of the support has been highly complex – and thus hard to understand.

A simple question for investors.  How do you evaluate risk?  When the government stops backstopping mortgages, the entire risk onus lies on Funds and Banks.  Till now they have been operating under the assumption that the government was always there as lender of last resort.  There have been two recent outcomes of the banking crisis:

  1. interest rate returns have been driven to almost zero from unlimited Government liquidity
  2. risk management has had government participation as its central focus

So how does a portfolio manager assess the risk on mortgage backed securities on their merits?  This lost art has been traditionally based on assessment of economic indicators, unemployment rates, inflation rates, purchasing power, and historic assessment of ones own portfolio.

We have the interesting situation where most of those indicators have been and remain negative or at best in serious doubt.  Stock market performance is irrelevant in considering consumer debt repayment.  So how will portfolio managers assess the risk of those MBS when they come on the market following withdrawal of the Fannies.  Will they ignore them because they have to ability to assess the risk?

There has to be a better way to assess risk, that is based on the consumers’ underlying data.


The problem with MBS (Mortgage Backed Securities) and any other ABCP (Asset Backed Commercial Paper) lies in the design.  It is a black box of consumer debt that is only has good as the bank which bundled it.  Bank A may have had a good record of MBS, so you choose to invest.  But really you are investing in the underlying promises from Bank A such as first loss, or making good on defaults beyond x%.  All this despite the fact that these securities are off Bank A balance sheet, but that’s a whole other post.

So really the risk is assessed based on gut feel for promises from Bank A and the economy.  There is not direct assessment of what matters – the borrowers contained in the MBS.

Enter peer-to-peer lending.  A set of loans in peer-to-peer lending services are not bundled.  Rather investments are made directly in the loans with platform capabilities enabling bulk purchases based on lender criteria.  But that criteria is assessed directly on the missing element from MBS – the borrower characteristics.  Lenders can see individual and aggregate debt service ratio’s debt levels, income levels, and stability indicators such as marriage status, home ownership, time on job etc.

Internet technology allows rapid assessment of many characteristics, with real-time updates.  Further the risk assessment is ongoing and while watching the evolution of the portfolio of borrowers.  What would have made this impossibly inefficient pre internet pervasiveness is now possible.

When we speak of transparency with peer-to-peer lending, this is in complete opposition to the ultra opaqueness of the MBS referred to earlier.

Going back to the dilemma confronting portfolio managers this spring – how will they assess risk?

Written by Colin Henderson

March 14, 2010 at 19:14

Posted in regulation

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