TRANSPARENT BUNDLES by Seth Goldstein

Transparent Bundles from Wall Street to Web 2.0

I am slowly starting to settle into a routine here in California.  The past few months have been filled with new beginnings- a new school for the kids, a new job and commute for Tina, new grocery stores and restaurants and little league fields.  The Taxi cab-hailing hustle of Manhattan has given way to hustling my bike to the top of Mt Tam. Ideas don't change at the same pace as activities, however, and I find myself thinking through the same issues about transparency that stimulated this blog in the first place.  Back then I was focused on soft dollars and the opacity of financial markets not media markets:

...soft dollars and bundled commissions are the vig that generates much of the wealth among the brokerage industry in New York, which in turn lubricates expense accounts at lunch time and grand Park Avenue co-ops and East Hampton beachfronts. Is it not ironic that New York has a mayor whose namesake company benefits more from monthly soft dollar payments than perhaps any other financial institution. In a way, Bloomberg has taken the notion of value-added brokerage services to the peak of civic duty. Our city itself reflects the residual value of opacity in financial markets. And so the question comes back to what happens to the brokerage industry when transparency become of more value to investors than opacity?

Three years later, soft dollar pratices are as opaque as ever.  The SEC has catered to the rich interests of hedge fund and stock brokerage lobbyists and enabled both sides to continue their practice of doing business with eachother in a very gray market.  Even the most sophisticated individuals outside of the financial services industry have little sense of what is really going on, in terms of the ways in which large institutional investors and large banks and brokers profit from closed data practices.

This is not that different from the dynamics of the online advertising environment- there are large institutional advertisers doing business with large media companies and advertising networks.  Despite the pre-text of openness and transparency, the online media market works hard to obscure the discovery of price by the very individuals producing it; namely the people who are using the medium, searching for things, clicking on ads, and conducting commercial transactions.  The web user, like the individual  investor, has resigned himself to letting larger interests capture, aggregate, and monetize his data behavior.  He has been led to believe that this is simply part of the bargain of having such "low" transaction costs for trading stocks or searching for information.

If I had to draw a continuous line through all of my disparate activities over the past ten years, this would be it:  identifying and interpreting the direct economic value of an individual data actor.  We may never in our lifetime see a day when a person develops an acute, vested interest in the value of his data; the spread between the value of a handful of clicks and that of a mass of aggregate behavior is significant.

Although it may be hard to keep track of the progression of Media Futures, we are stuck between the end of Alchemy and the beginning of Arbitrage.  This is where the creativity stops and the money kicks in; not that surprising against the backdrop of so much M&A activity (DoubleClick, RightMedia, StumbleUpon, etc.)

In May 2005, I made this transition in the first Media Futures series.  It was etymological in nature and only hinted at the real activities that I was engaged with as an entrepreneur, as I handed over the reins of Majestic Research to a new CEO in order to focus on creating Root Markets.  Flash forward two years and I am at a similar juncture; this time moving from Root in NY to AttentionSoft in SF. The transition from Alchemy to Arbitrage that I want to describe this time will be more personal, now that the philosophical ground work has been established.  I want to trace the evolution of a central idea- transparency- through the founding of a new investment research process in 2002 all the way through the creation of a new consumer data platform in 2007.

As always, thanks for staying tuned.

Wall Street 2.0?

 

Tom Glocer,  CEO of Reuters, stands in front of  Media Futures at the Open Data Conference in NY

And so, what does exhibitionism have to do with Wall Street? How does the voyueristic behavior of 20-somethings relate to the commission decisions of hedge fund masters of the universe? Traditionally, very little. Or at least we weren't aware of these connections.  Now, however, the advent of personal surveillance technologies has begun to popularize processes that up until now have been unavailable to individuals.

This resonates with a comment that Reuters CEO Tom Glocer made at the Open Data Conference.  It was the night before the conference, over dinner, that Glocer gave his perspective on the evolution of "open data" in the context of financial services. 

He told a story about the transformation of individual data points into market data.  Surprisingly, he didn't start with a traditional financial services firm, like Reuters, but rather with an individual Schwab customer. This retail trader, by virtue of her decision as to what to buy or sell and at what price, is the most granular actor in the price discovery machine.  As Glocer told the story, the online retail investor was the proverbial butterfly flapping its wings in Hawaii causing hurricanes in China.  Her only action was to trade a stock in her 401K account online; but unbeknownst to her, Schwab took this trading data, along with that of all of the other individual retail investors, and established a higher level trend.  This process reverberated up through larger institutional brokers like Goldman Sachs and ultimately exchanges like the NYSE.   At each step up in aggregation and abstraction, significant economic value was extracted.  Although this individual's behavior is too volatile in and of itself to offer much in the way of trend analysis, this does not mean that her behavior is worthless.

This is the foundation of Wall Street 2.0:  the individual data producer is beginning to wake up to the economic value she is creating. This economic value had in the past been appropriated by those aggregating up the data from above.   Our electronic behavior, whether it be querying a search engine, clicking on an ad, checking out a stock, or trading a share, is generating value for other people that are in a position to aggregate and sell this information to institutions, who in turn transform it into some other form that ends up getting sold back to individuals.   Alchemy... to... Arbitrage.  This is nothing new.  What is new, however, is the extent to which our behavioral trails are no longer hidden, but are instead now available to us via various modes of personal Attention services, also known as myware.   This is the window that Open Data flows through:

Open data is to media what open source is to technology. Open data is an approach to content creation that explicitly recognizes the value of implicit user data. The internet is the first medium to give a voice to the attention that people pay to it. Successful open data companies listen for and amplify the rich data that their audiences produce.

Web Alchemy, Josh Harris & Justin.TV

Web Alchemy

Exactly two years ago, in April 2005, I wrote the first chapter on Alchemy in the Media Futures series.  Over the course of history, Alchemy always promised more than it could deliver.  But it was this promise that captured the imagination of people and drew their Attention to the very impossibility of turning “base metal into gold.”

As it relates to the contemporary Web landscape, Alchemy represents the promise of automatic personalized media creation.  It is the nuclear fission of intersecting Web 2.0 services.  "Maybe, just maybe, if I go to Web 2.0 Expo I will find that one service that that connects me most fully?"  This is the process of extreme triangulation that we- maybe without even knowing- are trying to achieve every moment that we use the Internet to express ourselves. The process is not new.  But its reception is.

When Josh Harris broadcast his life in real-time on weliveinpublic.org in 2000, it was received as strange exhibitionism in SoHo.  He and his girlfriend Tanya Corin went online in a Warhol art-house kind of way.  It wasn't clear what exactly Josh was trying to prove, but like many I was fascinated by the embedded cameras he installed in the Turkish-style bath. On Day 93, long after Tanya walked out and Josh had left it to brokers to sell the 4000 sf+ loft on lower Broadway, a recently arrived journalist who needed a place to crash ended up minding after the apt while it was being shown to potential buyers.  All the surveillance gear was very much in place and there was a working live control room where all the cameras flowed into, as well as the external chatter from those across the community grabbing these streams.  This writer describes what it was like to be there during these last days:

I am doing laundry all the next day, sitting alone, and I learn how to take advantage of the chatters. After all, I am a visitor in the house of a man I do not know. But they, they've lived here for a while... I ask them if Harris allows people to smoke in the loft. I ask if they know where an iron is. In one particularly surreal moment, I realize I have lost my keys. I enter the chat room and ask if anybody happens to see where I might have left them. One guy tells me to check my pockets. And there they were. From The Cyber House Rules By Will Leitch, Jan  1, 1999

Eight years ago when he wrote this, we had a different attitude towards pervasive surveillance than we have today.   Now, as American Idol, YouTube, Twitter and countless other social media phenomena would attest, the quickest road to celebrity is via one's willingness to become-  physically or behaviorally- naked.

And so, how then to describe the performance of Justin.TV?  His omnipresent camera cylinder to the left of his perspective is like the pen-above-the-ear of a great investigative journalist- Dustin Hoffman as Carl Bernstein in All the Presidents Men.

Despite his camera, Justin doesn't care about coming off as a disinterested reporter.  There is no longer even a pretense that the subject drives the interview.  Maybe it's wrong to think of it as an interview at all.  The  recording instruments are so integrated and obvious that everybody Justin comes into contact with gets their own live studio audience.  This shifts the lens of narcissism from Justin to his audience, making him seem almost, well, selfless.

Michael Goldhaber recently defined a "star" as:

(When an attent typically has many audients, thus taking in more net attention than paying out, that person is of course a STAR.  )

On the Internet, this is based in large part on one's ability to express oneself openly, across multiple networks.  For example, in addition to the live video feed and community chat, Justin makes it easy for us to connect to him via shared social networks:

Justin wants people to pay close Attention to his stream and comment on his blog. This is exactly how stars enrapture their fans:  engaging them in production of the very stardom they wish to worship.  There is a significant difference between celebrity in the first Internet cycle and now.  It is not the tools that matter, since many of them have not changed dramatically, but a growing responsibility that more and more of us feel to express our unique, authentic selves online. Justin.TV, like Tia Tequila of MySpace, Reid Hoffman of LinkedIn, Mark Zukerberg of Facebook and Fred Wilson of Typepad, inspire us to be all that we can be online- to open up our API and let the data flow.   

This is the Summer of Love, 40 years later transposed onto the Web.

 

Breaking News: ROOT + CBOT = $ for Lead Futures

I am excited to announce the first official gesture in the financial securitization of Attention:

The Chicago Board of Trade, which was established in 1848, has invested in ROOT.  Bernard Dan, the CEO of the CBOT is  joining the ROOT board:

"More than 30 years ago, the CBOT was the first exchange to trade interest rate futures contracts.  Our partnership with ROOT represents an opportunity to be at the forefront of Internet lead futures trading, and we look forward to working with ROOT as this industry continues to evolve.”   For the full press release click  here

ROOT builds upon the thesis of Majestic Research, which was based on a new consumer data-driven research model.  After coming up with the idea, I met Tony Berkman who had been building complex quantitative models for large hedge funds and funds of funds.  Together we founded the company which continues today as the only independent voice of quantitative reason in the investment community.  The irony of today's announcement begins with the fact that Doug Atkin the CEO of Majestic was formerly the CEO of Instinet which helped usher in a generation of institutional electronic trading.  In December 2004,  I helped organize a conference for Majestic called "Does Online Shopping = Paid Search?".  The implicit thesis was that Internet Advertising was starting to look more like Wall Street than Madison Avenue.  It triggered the first of many blog posts about Attention, called  "Attention Markets":

"Keywords have no inherent value, but they do typify how both Madison Avenue and Wall Street are valuing the Internet economy circa 2003 (in the same way that impressions and page views signified such in 1998). Soon, keywords will become replaced by leads (or some derivation) and there will be a new group of old and new companies competing for the spoils."

This investigation led in the Spring of 2005 to the first Media Futures series and specifically the section on Arbitrage:

"But on the other side of the mirror, we are being watched.  Our queries are being mapped legitimately by companies looking to contact us.  If you are not careful, an errant click will be answered with a telephone call from a sales representative.  And so as we succumb to these performance-based networks, our future purchases, our future media consumption, our lifetime economic value across hundreds of categories and thousands of companies, are all being calculated in real-time.  Not by a single agent, but by multiple agents each trying to evaluate our momentary state of purchase intent in the context of the many monetization levers these advertisers have at their disposal."

Soon thereafter ROOT was born, originally with the fitting moniker IAG- the Internet Arbitrage Group.  My idea (developed in conjunction with the beautiful mind of Josh Reich) was that insofar as a company such as a mortgage lender was willing to take delivery of a lead, without controlling where it came from, then such a lead was a commodity.  And insofar as this lead commodity was just personal information along with an intent to enter into a transaction, well then it could be bundled with other leads and securitized in order to price it.  Looking for solid examples in history for this, I turned to my friend and advisor Andrew Bein who said this reminded him of the Mortgage Backed Security Market. 

I did some research and all roads pointed to Lewis Ranieri, the former Vice Chairman of Salomon Brothers and recognized inventor of financial securitization.  I located the following paragraph from Business Week and included it my appendix to the executive summary for IAG:

Business Week, November 29, 2004   
Lewis S. Ranieri: Your Mortgage Was His Bond
The bond trader turned home loans into tradable securities 

The past quarter-century has seen a revolution in finance. It's felt every time a homeowner refinances a mortgage or signs up for a credit card. No one person can claim to have lit the fuse for this revolution-- but Lewis S. Ranieri was holding the match. Joining Salomon Brothers' new mortgage-trading desk in the late 1970s, the college dropout became the father of "securitization," a word he coined for converting home loans into bonds that could be sold anywhere in the world. What Ranieri calls "the alchemy" lifted financial constraints on the American dream, created a template for cutting costs on everything from credit cards to Third World debt -- and launched a multibillion-dollar industry.

As many know by now, I subsequently met Lew in person and brought him on to join me as Chairman and lead minority investor in what is now ROOT.  The vision continued to evolve and clarify and I built a strong team of people to develop the concept for a true financial marketplace for Internet leads.  In October of last year I described it here on this blog for the first time:

Wall Street Meets Madison Avenue

What is a lead?
A lead is generated when a consumer clicks on an ad and is directed to a landing page—a web site that collects information critical to determining how valuable a potential customer is—and fills out a form.  This form includes both contact and intention information about the consumer.  This lead is then sold to an advertiser, who contacts the consumer to close the sale.

What is an exchange?
An exchange provides a context for giving and receiving.  It is a simple concept that solves hard problems, frequently in financial contexts: stocks, bonds, commodities, currencies, etc.  In these markets, exchanges provide price data and quality information about the underlying commodity.  Successful exchanges work hard to stay out of the way of market participants.  This means encouraging liquidity without providing any:  jujitsu not sumo.  With access to this data, traders with many different agendas can meet on the same, level playing field and compete.

Today in Business Week, Rob Hof reports on the full realization of this vision and how the CBOT has become the first Wall Street exchange to recognize one of the last great frontiers of unregulated arbitrage, namely the buying and selling of Attention on Madison Avenue.

ROOT was inspired by a series of blog posts and in less than two years established an entirely new financial security.  For the group of us who huddled together in a small office off of Brad's trading floor,  this is the validation of our dreams.  The merciless capitalism of Wall Street has moved uptown to take over the shopping windows of Madison Avenue.  Advertising will never be the same.

Now it is time for Attention to take control...

Thread 6: Lew Ranieri responds to Questions

QUESTIONS AND ANSWERS

Q:  It’s not easy to become an insurance company but it’s easy to become a broker.  So the question is, have you guys attacked any of that piece of it, not just the originations, but also the insurances that accompany them?

Ranieri:  There is nothing that says in the same way you get his lead from online you cannot deliver all this other kinds of information online, which is normally difficult in a traditional process.  Unless the consumer proactively tries to break out of the corral, it doesn’t happen.  Here he’s already out of the corral; he’s online.  You follow?  And I think what you’re going to see is a lead may become simply a sequence of leads.  The lead won’t simply be a lead for a mortgage.  You might sell the lead four times to four mortgage companies; but you may sell that same lead beyond that, because as sure as God made little green apples, there will be a sequence of insurance companies or title companies who want that same information.

Q: This is a question about the Exchange that you have built.  As you and I both know going way back in the lead generation business, it’s a supply driven business so if you can’t get the supply then there’s nothing to exchange.  So even though I agree with Lew that this could potentially be a big win for mortgage brokers because they’re getting more leads, better leads, a price based on the real value … even though I believe it could be a win for the consumer because probably they’re getting well-priced goods and services, I don’t see any reason in the world why any of the companies out there that are generating real estate or mortgage leads would want to cooperate.

Goldstein:  We call them aggregators, and they are generating supply across the industry:  LowerMyBills, Nextag, LendingTree, LoanWeb, Adteractive, there’s a number of them.  Many are quite good and are generating high quality mortgage leads that lenders are purchasing.  The Exchange is open and available to them at minimal cost as an opportunity to discover price and to clear inventory that only has 24 hours before it goes stale.  Some of them may have their own direct relationships where they’ll sell the lead once or twice, but for the third or fourth time they might use the Exchange.  Most of these aggregators purchase their media inventory from publishers.  A consumer of one of these aggregators is typically coming in through a search engine or a banner.  The natural suppliers of this inventory are the newspapers, the search engines, the media companies, all of whom up until now haven’t really had a channel to sell leads directly through.  They have had to sell impressions and trust that they are getting a fair price for their impressions relative to the value of the underlying leads they could be generating.  Many publishers are indeed getting fair prices, but there are some publishers who have relevant search terms or relevant content areas that might monetize better it they were able to go directly to our Exchange.  And so we are committed to enabling both traditional publishers who are capturing the direct attention of the consumer and aggregators who, in most cases, are purchasing media to generate leads. 

Ranieri: In the regular, non-refi mortgage business, that volume is not controlled by an aggregator; as an example, it’s controlled by realtors.   Realtors turn those leads into money simply by, at this point, becoming a mortgage company to convert the lead into their own servicing.  I think I could argue if this process is as efficient and powerful as I believe it will be, they will be a lot better off just accessing our Exchange.  It will be much more cost effective.  Every homebuilder in the country decided they had to become a mortgage company to capture that portion of the revenue.  Our Exchange will give them the ability to exit a business they really never wanted to be in.  They just want to keep that portion of the income that came from the result of building the house.  This gives them a much more cost efficient way of doing that.

Q:  That’s why I’m saying it’s great for the demand side but maybe it’s not so great for the supply side.  If I’m a publisher and I’m making $10,000 a month from an aggregator, why should I drop them and sell leads directly to your Exchange?  I think you’re going to get some resistance.

Ranieri: One of the largest mortgage companies in America at the beginning of all this was Loomis and Nettleton, and they were a monopoly.  They viewed the advent of the mortgages security market as a risk, as something that was competition because in those days mortgage companies were brokers.  They weren’t what mortgage companies are today.  They actually simply brokered a loan between thrifts or between thrifts and pension funds.  And here I was suggesting that mortgage companies become originators:  get into the mortgage business themselves, take the mortgages they create and turn it into a security and sell it.   So that their whole business wouldn’t be going to the Arizona Banking Conference and lining up four new thrifts to sell them into.  But I was preaching heresy.  And this great, giant company, Loomis and Nettleton decided “a pox on my house” and that they weren’t going to change.  And unfortunately it turned out for them that I wasn’t all wrong.  And there’s no longer a Loomis and Nettleton. 

Goldstein: But there were plenty who adapted to the evolution.

Ranieri: It was actually good for mortgage companies.  In fact, if it was bad for anybody it was bad for the thrift who wanted to show up at 10 and go golfing by 3.  The mortgage companies inherited the earth. 

Q: Your comments about refinance product were focused largely on refinancing to a fixed rate product, any thoughts on the option ARM product?

Ranieri:  We’re talking about a very sensitive topic so I’ll just take it on head-on.  Option ARMs in their original design were created for middle income, upper-middle income people who understood the nature of the risk in the option arm and for whom it worked very well because they could manage the risk.  They could de-lever if they so chose.  That was the issue; you could de-lever.  When the option ARM started to be used as a vehicle to qualify the unqualified, it became an abuse, in my opinion.  Actually, the first arm was called a floater.  The first ARM structure wasn’t called an ARM, it was called a floater and the rest of us called them sinkers because in the next cycle they never ever hit par again.  So an option arm in its most aggressive form where you have a 1%, then it rolls to a 1% initial for 90 days, 4% and then it rolls to fully indexed after the year.  And you can choose to stay at 1 percent.  Think about it.  That’s an 85% loan to value and you choose to stay at 1%. In less than two years you’ll be at 115% loan to value and you can’t go anywhere.  I’ll write in blood for any of you who want to have this bet with me.  I will tell you there’s a 100% correlation between equity and foreclosure.  Nobody lets you take a house that he has net equity in and nobody tries to stop you when he has negative net equity.  So you drive a loan up to 115% in two years, unless housing’s appreciating to offset that, you are going to have an unhappy amount of delinquency and loss on foreclosure.  So I think the option arms are a very useful product as long as you don’t use them for what they were never designed for.

Q: Servicing value?

Ranieri:  Servicing value will follow, depending on who’s buying the servicing.  Thrifts were for a very long time very naïve about the risks to certain kinds of consumer and option ARMs and so the option ARMs were 5/8’s of a point regardless of whether they were upper-middle class or being used as a way to qualify the unqualified.  Then the FDIC, the regulators, the federal financial oversight group came out with guidelines and said to financial institutions, banks, credit unions and council and state insurance companies: “If you do this, I have news for you.  You can do it.  We won’t stop you.  It’s not technically illegal, but when we come in, we’re going to ask you to do a series of algorithms and if you cap out in two years we’re going to make you write these things down; we’re going to make you take reserves against it.” And so the aggressive AM arm loans now are trading at pretty substantial discounts to the 5/8s and 3/4s of a point based on those regulatory algorithms.

(Thread 6/6 of RootExchange/s speaker series: #2 June 13, 2006 with Seth Goldstein interviewing Lew Ranieri at NY office of Root Markets)

Thread 5: Lew Ranieri on Internet Lead Quality and Consumer Value

Seth Goldstein:  One of the issues I think a lot of people deal with in the online advertising market in general and in the Internet lead market specifically is how to evaluate the quality of the lead.   How do you address the quality dynamic?

Lew Ranieri: Define quality, because when you say quality…

Goldstein: Conversion.

Ranieri:  You need to tell me what he conversion rate is, and what loan it’s converting into.  So am I multiplying the conversion rate by 5/8s or a point and a half?  Is it converting into a 30-year, because remember, there’s more than one mortgage market.  There’s the low income FHH market.  There’s the big one, the conforming market.  And then there’s non-conforming like in this world and California much of the product is non-conforming and because of the balances that stuff is generally worth more money.  So again, I just need to know what I’m multiplying it by to figure out the value of the lead.  So if quality is being used by you to simply mean the conversion rate, you need to be able to ascertain independently, unless somebody’s going to guarantee it for you, what the conversion rate is and you need to get enough information to do that effectively.  The mortgage guys will eventually make you pay attention to pricing it this way.

Goldstein: How does this relate to the mortgage market in the ‘80s in terms of ratings agencies and the evaluation of quality?

Ranieri:  We pulled the regulators into it because we needed somebody who had the power to standardize.  The non-agency market, the non-conforming market took longer because we had to do it with money; we had to do it ourselves by imposing rules upon ourselves and then agreeing to abide by the rules we were imposing (and ostracize those who refused by putting them on a black list).  It worked because you want to do business and if everyone else decides to black list you because you’re always monkey-ing around, eventually you decide that it’s not worth your interest to monkey around.  But this takes longer than a regulator saying: “here are the rules, sign this piece of paper, and oh by the way if you monkey around I’m sending you to jail”.  There’s something about those last words, which have the ability to make you pay attention. 

Goldstein: How did the mortgages evolve from being a narrow, housing-specific market to the trillion-dollar bond industry that is has become today?

Ranieri:  Mortgages became a vehicle not simply for housing, for the financing of housing, but it became an asset class for people to invest in.  People use it as a proxy for the movement of interest rates because it’s so big.

Goldstein: Clearly, that was great for Wall Street and Salomon Brothers, but my question is how did that benefit home owners?  How did that benefit the banks?

Ranieri: It’s called liquidity, liquidity, liquidity. I’ve developed a lot of markets, not just mortgages, and in every one of them your knee-jerk reaction is always: “I like my big fat spread, leave me alone. I like it this way, go away.  I don’t want to hear about an exchange.  I don’t want to hear about a security.  I don’t want to hear about standardization.  I’m making a lot of money.”  Markets that grow to the size that I believe the leads business will, these markets never become totally homogenized.  The generic will become the department store special, but there’s always the edges.  I think you will see, in a very short period of time, that the new sex symbol of Wall Street will be the lead trader. 

Goldstein: Ok, but how do consumers benefit?  For example, how did the securitization of mortgages help people?

Ranieri: By lowering the cost.  All of housing rests on two pieces of legislation both of which I helped to write:  The Secondary Market Enhancement Act, which was passed in 1984 and the Tax Bill, which is called Remick, which passed in 1987.  New markets don’t have that security web of regulation.  When we went to Congress and asked Congress to pass a bill, you can imagine the strange looks we got.  We had to agree on the first bill that there would be a “look-back” 4 years later and the look-back said that: if they gave us this bill we would be able to lower the cost of housing by 250 basis points.  And so Congress ordered a review and if we had not met or exceeded that promise, the bill would have died. We ended up lowering the cost of housing by much, much, much more than that. 

So, one of the ways I think the consumer will benefit here is through the democratization of information.  The mortgage business has lived for a very long time by trying to capture the consumer, by trying to keep him fenced in.  So if he comes to me to build a house, I want to sell him my house, but I’m not going to tell him to go call 40 realtors to get a mortgage.  I want him to go to my friendly neighborhood realtor to get a mortgage because I’m going to get some part of that fee.  And I’m probably going to try to sell him homeowner’s insurance as well.  If I have a special deal with Anderson Windows, I’m going to try to get him to upgrade into Anderson.  That’s just the nature of the world.  The web has become the major vehicle of intention information. It’s much more difficult to keep consumers fenced in.  It is easier for him to bracket what is a good loan and what is a bad loan because not only is he getting freedom of access to all of the forms, he’s getting freedom of access to information about people who are prepared to tell him about the risks of a given loan.  RootExchange is in the center of this movement. 

(Thread 5 of RootExchange/s speaker series: #2 June 13, 2006 with Seth Goldstein interviewing Lew Ranieri at NY office of Root Markets)

Thread 4: Lew Ranieri on Internet Mortgage Leads

Seth Goldstein:  How does this relates to mortgage leads?

Lew Ranieri:  A lead is nothing more than an opportunity to close a loan and a loan is all about the value of the servicing that’s being created.  One of the most important aspects is what kind of a loan? So, the golden opportunity in the land of refinance leads today is that you can roll a refi not into another ARM which is only worth five-eighths of a point but into a fixed rate loan which is worth a ton more.  A mortgage geek, not a lead geek would tell you to pay a lot more because what you would be rolling it into is a 7- or a 30-year, the value of which is almost twice as much as a traditional ARM.  And there is roughly something in the neighborhood of about $600 billion of this stuff rolling up to the cap, so there’s a lot of refi business.   So for the time being, even with rates going up on the short end, we will have a new generation of refi leads and refi business in general.  But for housing in general, which is slowing down because of the absolute level of rates, you are starting to see some problems.  The most obvious and the most problematic are in the condo market in states like Florida, Arizona, New Mexico, Las Vegas, places like that because we  misjudged the amount of speculative inventory that was out there.  Much of what was sold as legitimate second home inventory turned out not to be a second home, turned out to be spec. 

And now with a perception on the part of the consumer that housing values aren’t going up, that stuff is flying back in our face at extraordinary levels.  To date it’s largely a creature of the condominium market not of the single-family market.  But traditional single-family housing in some markets is struggling.  I’ll give you a personal example.  I live on Long Island and in Merrick, Long Island, a middle-class neighborhood, you never saw a house for sale.  It was always sold before it ever went on the market.  There are now 222 listings in Merrick.  That’s an unheard of situation.  So you are starting to see a slow down in housing and you may see some price decline. 

SG: If you could “short” one type of customer and go “long” another type of customer, what would it be?

LR:  The refi business will go through a cycle maybe, not by volume but by value, because instead of refi-ing in the five-eighths servicing, you’re refi-ing into a point and a half servicing.  Now that’s a pretty good deal.  So, the guys who can keep the volume up, or even three-fourths of what the other volume is, the actual value of the roll will do very well.  I think your industry, the lead industry as far as mortgages are concerned, has to sooner or later make the adjustment to deal with what is the real nature of housing forever, which is not just refi’s.  We’re at a 45-year low in rates.  It’s an easy mathematical bet to say which way rates are going.  Just say up and you’re going to likely be right.  If you’re at a 45-year low, in that environment refi will go back to its more traditional role and the vast volumes will be in the traditional process of housing: new construction, home improvement and resale. The lead business has to adapt to that business because that is the business.  That is the one that will be there year in and year out.  It will only expand and diminish on the margin and the value of the asset created is the more valuable asset in the first place.  The first lead guys who figure out how to cut the Gordian knot and do new construction will be successful. 

It’s kind of interesting to me to look at the fact that nobody wants to buy leads for new construction because the mortgage guy has the world turned on its head.  But the new home purchase lead is a more valuable asset!  It’s got the most servicing, value, plus the person who buys the house is likely to buy all the insurance programs.  The refi guy isn’t buying insurance; he’s already bought them.  So a lead for a new construction lead is worth more than the lead for a resale buyer and certainly infinitely more than the lead for a refi.  And yet, in the RootExchange spot market today, that’s the least valuable lead and the one that frequently goes unbid for.

(Thread 4 of RootExchange/s speaker series: #2 June 13, 2006 with Seth Goldstein interviewing Lew Ranieri at NY office of Root Markets)

Thread 3: Lew Ranieri on the History of Securitization

SG: Go back 30 years, and it’s 1976.  What was the mortgage market like prior to securitization?

LR: We made a lot of money then.  In many ways it looks like the lead generation business in that there were no simple definitions for a basic mortgage.

SG: What was the perception of a mortgage back then?

LR: Well, there wasn’t a mortgage-back security then.  The first mortgage-backed security (MBS) was created in 1979 and it was a total failure.  It’s now the biggest market in the world but it didn’t start so well.  The MBS was created for Bank of America at the end of 1978 / early 1979 after seven years worth of work and it was a AAA-rated security and the deal was a total bomb.

SG: And what did you have to do with it?

LR:  Eat it. The mortgage security market grew up over a long period of time and required a safety net of regulations and customs to support them.  The mortgage security business existed inside my head.  It was no such thing and we were fortunate enough to make it happen in a few years.

SG: How did you see a mortgage differently than other people perceive them?

LR:  The system that came out of WWII was a specialized system of lends.  So, banks because their liabilities were short-term through money markets, made short-term loans.  They’d lend to corporations on a floating rate or fixed basis.  Insurance companies, because they made life policies, which were very long and therefore were long-term liability, made the infrastructural loans.  They lent to corporations and they’d build highways because they had long-term liabilities.  Thrifts were chartered for a special purpose, to support the soldiers coming home and the need for new family formation housings. Thrifts were specialized housing lenders.  So you would go to your friendly neighborhood thrift and get a mortgage and he’d put it in the portfolio and never be seen again.  Mortgage was not an asset you could trade because everybody had his own underwriting criteria, even his own documents. The first problem with this thrift was to figure out how to take this amorphous mass of things and turn it into a vehicle that could be traded; which is again a terrific analogy to the lead generation industry today.  The leads business, whether you talk about mortgage leads or credit card leads or car leads, is the same sort amorphous mass of things.  They are not designed to be traded, but rather to be moved in a first mover way – I sell it to a guy who then tries to originate the loan, he puts it away and end of story.  But you don’t hear anybody trying to create a futures market on leads or short a lead or write an option on a lead or guarantee a conversion price or all kinds of things that more normal markets would do.  They’ll come.  All of those things will come.  That’s our vision for RootExchange.

SG: How did you force standardization?

LR:  Money: the same way the leads business will do it.  If you look at the pricing of a lead versus the value of the underlying asset and assume a reasonable conversion rate, they are much more attractive as an origination channel than wholesale or retail or builder or realtor or any one of the normal mortgage channels.  The real issue is the conversion rate.  And so a mortgage company could pay a tremendous amount more for a lead if he had any confidence in the conversion rate,  because of the disparity between the value of the servicing and what people pay for leads.  If the conversion rate is 1-2%, just do the math yourself.  If the two of them convert, and you’re converting as you would now in refi land into 7/1 servicing, then it’s worth a point and a half and you’d pay a lot for leads. 

SG: More than 30 or 40 bucks.

LR: Yes.  Well, think about, it’s simple math.  A 7/1 is worth 1.5%.  Think about 1.5% and then attach whatever conversion rate you want and see what you can pay for leads.  I mean, that really should be the math because of what you’re converting into.  Right now there are very few traditional 1 year ARMs, but if you want to use those as a California ARM, that servicing is worth, actually right now it’s close to three-fourths because there’s so little of it but normally it’s worth five-eighths.  So work backwards.  You can go to a screen.  You can go to Bloomberg and look at the value of the servicing.  People buy and sell servicing all day so you can tell what the end value of whatever you’re talking about is by simply looking at the servicing and then if you want to make a simple algorithm, just times it by the conversion rate. 

SG: So does price discovery and quality discovery help move the mortgage leads market into and through securitization?

LR: Yeah, markets are like humans. They like the way things are done, they’re used to it.  So you need to pull them off that inertia in some way and it’s usually the old fashioned American way.  It’s called money.  You generally get people to pay attention because you’re willing to pay for it.  If the market can’t pay you, you’ll do it the way you’ve been doing it for 20 years because it’s comfortable and you know what the risks are.  We used to say:  “We know who the pioneers are.  They’re easy to identify.  They’re the guys in the road with the arrows in their back.”  So unless I give you a financial incentive to go and try to do it differently, you don’t want to volunteer to be one of the guys in the road with the arrows in your back. 

(thread 3 of RootExchange/s speaker series: #2 June 13, 2006 with Seth Goldstein interviewing Lew Ranieri at NY office of Root Markets)

Thread 2: Lew Ranieri on Housing Bubble

SG: Will the housing bubble burst?

LR:  I do not believe almost anywhere in the country this supply demand situation is so out of whack that you’re going to see a traditional bust.  Mortgage lines rarely actually bust.  In fact, I think that in the entire history of mortgages post WWII, we’ve only actually had five busts.  When mortgage markets reach a problem, they generically stop going up and stay the same for 5 or 6 years. That’s how they work themselves out.  They rarely drop out of bed.  In the five instances where mortgage markets have dropped out of bed, it was because of extraordinary circumstances.  Texas during the 80’s when the oil patch blew up and people left Houston hand over fist so the reason housing went down so much is not that interest rates were too high or the price of the house was too high, there was just nobody to sell them to.  I mean, there were more people trying to sell houses than there was anybody to sell them to.  That was the same situation in Southern California in the early 90’s when the inland empire looked like it was about to become Atlantis.  It wasn’t a matter of rates; it wasn’t a matter of anything other than just overcapacity and lack of buyers at any price.  So, housing’s slowing down, but I don’t expect it to be a disaster.  I think where there may very well be problems, significantly in the sub-prime area.  Sub-prime is a creature of the last 5 or 6 years.  It historically has never really existed so it did not exist through a cycle.  This will be the first cycle, and the combination of high loan values and somewhat aggressive underwriting makes those loans susceptible to even a marginal decline in housing values. 

(thread 2 of RootExchange/s speaker series: #2 June 13, 2006 with Seth Goldstein interviewing Lew Ranieri at NY office of Root Markets)

Thread 1: RootExchange/s with Lew Ranieri

On June 13, 2006 we hosted our second session of the RootExchange/s speaker series.  Our first speaker was Michael Goldhaber, the leading philosopher of our emerging Attention Economy.  This second session featured Chairman of Root Markets, Lew Ranieri.  As Vice Chairman of Salomon Brothers in the 80's, he pioneered the mortgage security market and helped turn it into the trillion dollar market it is today.  Ranieri shared his insights on the housing and mortgage markets, and described how the Internet promises to introduce further efficiencies to benefit consumers, publishers and lenders.

Seth Goldstein: What inspired you to become involved with Root Markets and how does it relate to your perspective on the evolution of the mortgage customer acquisition market?

Lew Ranieri:  About a year ago you started talking to me about your vision “the lead business” … I must admit I’d never heard of it before.  I’ve built a number of banks and some of the largest mortgage companies – I was the founder of what became GMAC Mortgage before there was a mortgage business.  “Lead generation” … what does that mean? When I started to understand it, what became apparent to me was that this is potentially the most powerful origination channel across all the consumer areas. I truly believe that from a trader point of view. I’m a trader. I’ve built businesses and owned companies, but the only thing I’ve ever really loved was trading. The good thing about trading is that you come in in the morning and at the end of the day you know whether you’ve won or lost.  I remember when corporate bond traders were kings of the world.  And then it was junk bond traders.  And then mortgage traders.  I will make a prediction for you: I think that very shortly the new sex symbol for Wall Street will be lead traders;  because I really do believe that as a channel, this is the most powerful technology I’ve ever seen.  It’s in its infancy, it’s ruthlessly inefficient, in many ways it makes very little sense in the way things are being priced, but it has embedded in it the seeds of an extraordinary potential because it’s totally variable cost.  It operates where the consumer has migrated to.  It’s based on the most powerful consumer force, namely the democratization of the access to information.  It’s just extraordinary in its breadth and in what it could become.  So since I have an innate desire to continue to become wealthier, I thought this was a really interesting place to get involved in

SG:  Juxtapose that with your outlook on the mortgage market, both that which is driving online advertising, which is primarily focused on refinance, and what you call the “real housing market.”

LR:  One thing that surprises me about the lead generation business is that when people say mortgages, they mean typically mean refinance (refi).  Normally, when mortgage people are saying mortgages, refi is this other thing that happens periodically when rates are going down because the rest of the time there is no such thing.  The basic process of housing is new construction, resale, home improvement.  Refi for us is a “sometimes” thing.  It’s been a great stretch over the last seven years as rates have come down and everybody’s been refi’d at least one and a half times.

SG: What is your outlook on interest rates?

LR:  My outlook for interest rates should not be surprising to many of you.  I think Bernanke will over-compensate and that interest rates will tighten too much because he believes that to be the safest course.  He feels that it’s easier for them to reverse the course from an over-tightening situation and stimulate the economy than it would be to let interest rates take hold which will take a much longer period of time and be much more painful to stamp out.  So they’re much more prepared to create a recession than they are to allow inflation to take hold.  I think Bernanke, in order establish his bona fides as a certified inflation fighter, will have a double reason to want to overcompensate so I think they will tighten on the front end.  Although the economy, in my opinion, is already starting to slow down.  Energy prices take a long time to work their way through the economy. So, with the tightening that I believe that they will do, we will wind up in a position where we’ll invert the curve more.  We may actually get to one of the more inverted curves with all of those implications, and I can see 18 months from now we might be going the opposite direction with great haste.

SG:  What are the implications for housing?

LR:  But what does that mean for housing?  Well, you’re already starting to see it.  You’re seeing an absolute slowdown on the part of the consumer.  Those of you in the mortgage business know that volumes are off substantially across the board.  That’s likely to continue.  It’s creating some interesting opportunities in refinance because – this is probably the first period since ARMs have been in existence where they’re actually going to roll to the cap at a point when the 30-year rate is lower.  Most adjustable rate loans and a very substantial amount of adjustable rate loans are not rolling to their cap, and note that cap is somewhere between 7 and 7.25 so many consumers are now looking at a 7.25 mortgage rate when the 7-year or 30-year fixed rate is well below that, 6.5 as an example.  So it’s unlikely that a consumer is going to start paying 7.25 or 7.5 when he can just refinance into not another ARM, which used to be we could roll ARMs forever.  Now we’re not in a roll ARMs, we’re actually in the unique position to roll ARMs into fixed rates.

(continued)