The Software Cure For A Financial Meltdown

Thursday, January 22, 2009

In my role as amateur financial analyst I like to read the publications taking an in depth look at the current financial turmoil. I then try to imagine the software tool that could have prevented the turmoil and saved the world millions billions trillions gazillions of dollars. This seems like no small feat for software considering the intricate world built by modern financial engineering - a world where terms like “collateralized debt obligation” are tossed around like dice at a craps table. However, I never imagined the answer could be so simple …

First, some background. I find the current situation interesting because ten years ago I joined an Internet startup by the name of Ultraprise.com. At Ultraprise, we tried to create an online exchange for the secondary mortgage market. Let’s say you have a bit of money saved and want to buy a house, so you find a bank that will loan you the rest of the money you need to buy the house.The bank could then wait for your to repay your loan over the next 30 years and slowly make money on the interest they charge you, but many banks just want to sell your loan to someone else and receive cash in return. Wikipedia has solid coverage of this process in the Securitization entry. The fresh cash received from the sale of your loan allows the bank to stay liquid and fund more loans. But, to sell the loans the bank needs to find a buyer, and this is where Ultraprise came in.

Fannie and Freddie pick up roughly half of the mortgages in the U.S – that is their job, but the rest of the pie is still a substantial amount of debt for sale. At Ultraprise we built a web application for banks to upload pools of loans they wanted to sell. Buyers could then login and bid on the pools. The idea was to cut out the brokers who typically sit in the middle of these transactions and take a cut. Economies of scale meant our fees would be substantially less than the typical fees.

Fail

Ultraprise was out of business after three years, despite having a substantial number of loans posted in the system. We couldn’t sell loans. Part of the problem was, I think, that the people who buy loans really like the human touch that a broker adds. Rib-eye steaks and martinis sell more products than a dull web page full of numbers.

Another problem was getting mortgage data in and out of the system. There was no standard format for pushing mortgage data. Every bank with a loan for sale required a custom import, and every bank looking to buy loans wanted to download data into their custom software for analysis and due diligence.

My experience at Ultraprise led me to believe that banks were exceedingly risk averse and highly analytical, and that they required lots of data before making decisions involving millions of dollars. Thus, I was quite surprised to learn that today’s banks have no clue about the cards they are holding.

“ … a major stumbling block for banks is having the right data on hand …”  - American Banker

“…the reason that banks don’t want to lend to each other anymore is that they don’t trust that the other banks really know the value of their mortgage-backed securities … because they themselves don’t trust the value of their own.” – Aster Data

All this secrecy comes in the wake of an economic crisis brought about in part by a proliferation of financial instruments so opaque that virtually no one understood the risks.USA Today

Epic FailCDOs Collapse

There have been documented changes in the mortgage industry since Ultraprise closed. For example - the lowering of lending standards allowed banks to give more money to people with lower credit scores. However, the outstanding change from my perspective was how those loans were sold to investors. What follows is an extremely gross simplification.

As subprime lending increased, the banks found it harder to sell pools of loans. The risks were too high for the big-money conservative investors like pension funds, and the possible rewards were too little for the hedge funds addicted to double digit growth. Thus, the rise of the aforementioned collateralized debt obligation, a.k.a the CDO.

The investment banks use CDOs to package mortgages, subprime loans, home equity loans, automobile loans, credit card debt, corporate debt, and used cat litter into products they slice up and sell to investors in private offerings (with the help of strippers, martinis, and appalling judgments by our trusted credit rating agencies). 

However, not all of the slices from a CDO are an easy sell (particularly the ones filled with risky loans and cat liter). So … firms will create a CDO squared (CDO^2) from the undesirable slices of multiple CDOs – essentially dressing up pigs with lipstick for the next big investors ball. You can be assured that a CDO cubed (CDO^4) will then arise from the dumping grounds of multiple CDO^2s, and then … well … CDO^N should give you an appreciation of how deep into the rabbit hole an investor can fall.

Investment banks issued hundreds of billions of dollars in CDOs over the last 5 years. Why did the risk averse investors, like the banks and the pension funds, stand in line to buy these CDOs and the other credit derivatives that Warren Buffet labeled “financial weapons of mass destruction”?

In part because a CDO does a good job of obscuring it’s underlying qualities– the loans, the assets, but most of all the risk. It was all a sales job, and something that an unknown software company could never pull off. 

Then How Could Software Help?

The $765 million “Mantoloking CDO 2006-1” was underwritten by Merrill Lynch and is the prime example of a “toxic asset”. The Mantoloking, a CDO squared, was built from the unwanted slices of 126 other CDOs, and is perhaps the most infamous CDO because its spectacular losses facilitated the disappearance of at least two hedge funds. You can find the 200 page prospectus online. It’s a lot to digest. In his paper “The Credit Crunch of 2007: What went wrong? Why? What lessons can be learned?”, esteemed financial engineer John C. Hull says transparency is needed.

[CDOs] … are arguably the most complex credit derivatives that are traded. Lawyers should move with the times and define these instruments using software rather than words

Sound familiar? To me it sounds like the software practice of using executable specifications - TDD and BDD for the financial world. No one can hide behind wordy documents and inflated credit ratings. They have to look at real numbers. The only question is - do we write these specifications in C#? Ruby? Haskell?

It turns out that Mr. Hull already had a language in mind. You can find it in his paper as footnote #8.

Given its widespread use in the financial community VBA is a natural choice for the programming language. 

What? A Microsoft Excel spreadsheet with macros might have saved our banks, our brokerage accounts, and our retirement funds?

It’s a stretch, but with the proper models in place it’s certainly a step in the right direction. Mr. Hull’s paper has other prescriptions for the finance world, too, as software is only part of the solution. You can never stop anyone who wants to skip due diligence and go directly to short-sighted greed, but I’d like to think that if our industry could make good software more readily available to the business world, the problems we are experiencing today wouldn’t be quite so bad.


Comments
Michal Talaga Thursday, January 22, 2009
If your're a financial analyst, you will certainly find http://mises.org interesting.

It will change the way you look at finances in such a way, that your life will never be the same.

I know. I was changed.
russellH Thursday, January 22, 2009
"Fannie and Freddie pick up roughly half of the mortgages in the U.S – that is their job, but the rest of the pie is still a substantial amount of debt for sale."

I think that is out of date. The articles I've been reading say the vast majority of purchases are now done by Fannie and Freddie.
scott Thursday, January 22, 2009
@russelH- You might be right - I couldn't find an exact number. I know Fannie/Freddie started taking in subprime loans, but I also think Wall Street was aggressively getting into the act. With CDOs they found a way to profit from surging real estate.
yipyip Thursday, January 22, 2009
How would yet more software really help when so much of this collapse was brought about by intentional deception and fraud?

It's not that Wall Street didn't have computer models, it's that they intentionally created simplistic, inadequate models and then fed them bogus inputs. I saw this documented in a number of places; I remember the New York Times had a bit on this but I can't find it now.

So how exactly would you work around the malicious operators of the software?
Michal Talaga Thursday, January 22, 2009
Predicting the future is impossible by definition. Any attempt is bound to fail.

For all those who still think the market was the cause of the crisis: stop doing that!

Governemnt regulations are the cause. Period.
Eric Friday, January 23, 2009
Thanks for the very interesting article.

Ira Glass (This American Life on NPR) had a couple of interesting radio shows on the subject.

355: The Giant Pool of Money
www.thisamericanlife.org/Radio_Episode.aspx

365: Another Frightening Show About the Economy
www.thisamericanlife.org/Radio_Episode.aspx


Also in regards to what 'yipyip' said, here is a quote from show #355 --

Alex Blumberg: It's easy to ignore your gut fear when you are making a fortune in
commissions. But Mike had other help in rationalizing what he was
doing. Technological help. Mike sat at a desk with six computer screens, connected
to millions of dollars worth of fancy analytic software designed by brilliant Ivy league
math geniuses hired by his firm, which analyzed all the loans in all the pools that he
bought and then sold. And the software, the data ... didn’t seem worried at all:

Mike Francis: All the data that we had to review, to look at, on loans in
production that were years old, was positive. They performed very well. All
those factors, when you look at the pieces and parts. A 90% NINA loan from
3 years ago is performing amazingly well. Has a little bit of risk. Instead of
defaulting 1.5% of the time it defaults at 3.5% of the time. That’s not so bad.
If I’m an investor buying that, if I get a little bit of return, I’m fine.



page 10 -- www.thisamericanlife.org/.../355_transcript.pdf





yipyip Friday, January 23, 2009
I found the NY Times piece (yay for Firefox 3's ginormous history and search functions): bits.blogs.nytimes.com/...

Pertinent quote:

--------------------
“There was a willful designing of the systems to measure the risks in a certain way that would not necessarily pick up all the right risks,” said Gregg Berman, the co-head of the risk-management group at RiskMetrics, a software company spun out of JPMorgan. “They wanted to keep their capital base as stable as possible so that the limits they imposed on their trading desks and portfolio managers would be stable.”
--------------------
Scott Mitchell Thursday, January 29, 2009
Interesting post, Scott.

I agree that software can be used to help analyze financial data, but any financial instrument that is so complex that it *requires* sophisticated software to understand or analyze it is a disaster waiting to happen.
Adron Friday, February 6, 2009
Along with mises.org just review any of the dozens if not hundreds of books, or basic Adam Smith, Keynes, or a dozen others.

Plenty of software detected the trend would explode. Thousands, if not millions knew it would, but they refused to act or do anything about it.

In addition the legislative situation is prone to forced competition for the sake of competition when there shouldn't be. Also with direct entities like Fannie and Freddie creating a manipulator that encourages unsafe loans, debt, and a fractional federal reserve system that gives us zero reason to save money. In addition to the fact that now, between the fed and the fiat currency we have zero ability to functionally save.

Thus everything is in the market no matter what, and the market dictates everyone.

...it is, a sad sad affair.
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