It looks like it's time for everyone's favorite whipping boy, "financial innovation," to come in for another round of mockery in the blogosphere. Simon Johnson and James Kwak make all the familiar arguments about CDS and CDOs, neither of which they seem to understand in the slightest. Their discussion of CDOs is particularly specious:

The magic of a CDO, as explained in the research paper "The Economics of Structured Finance" by Joshua Coval, Jakub Jurek, and Erik Stafford, lies in how CDOs can be used to manufacture "safe" bonds (according to credit rating agencies) out of risky ones. Investors as a group were willing to buy CDOs when they would not have been willing to buy all the assets that went into those CDOs. We don't have to decide who is to blame for this situation—structurers, credit rating agencies, or investors. The fact remains that at least some CDOs boosted financial intermediation by tricking investors into making investments they would not otherwise have made–because they destroyed value.
This is usually how CDOs are portrayed these days: they're obviously voodoo finance, because—get this!—they claimed to take a bunch of risky bonds and transform them into a super safe bond. What a ridiculous idea, right? Now do you see how useless financial innovation is? Of course, this isn't a remotely accurate description of CDOs. Notice how they conveniently leave out the explanation of how CDOs transform risky bonds into a safe bond. They do this through subordination and various other credit enhancements. Say we have a CDO with a $100 face value, backed by a pool of BBB-rated mortgage-backed securities. The CDO sells three classes of bonds: an equity tranche, a mezzanine tranche, and a senior tranche. Investors in the equity tranche will take the first 10% of the losses; investors in the mezzanine tranche will take the next 15% of the losses; and investors in the senior tranche will take the rest of the losses. Investors in the senior tranche wouldn't suffer any losses unless and until the total losses on the CDO exceeded 25%, so we'd say that the senior tranche has a subordination level of 25%. When Johnson and Kwak say that CDOs "manufacture 'safe' bonds out of risky ones," the "safe" bonds they're referring to are the senior tranches. But as you can see, the idea that the senior tranche would be "safe" isn't at all ridiculous—after all, there's almost always some level of subordination that will make the senior tranche a safe investment. The problem, in very broad terms, was that the lending standards on the underlying mortgages significantly deteriorated, while at the same time the rating agencies were handing out AA and AAA ratings to tranches with lower and lower subordination levels. I can't find a similar chart for CDOs, but this chart of CMBS subordination levels is instructive (the trend for CDO subordination levels was similar):
But of course, we get no discussion of low subordination levels—or even the idea of tranches—from Johnson and Kwak, who use the term "CDO" as some sort of trump card, the mere mention of which automatically ends any debate on financial innovation. This apparently passes for Serious Commentary nowadays. Felix Salmon, in discussing Johnson and Kwak's article, says that it's (finally) time to "make some nicer distinctions than have generally been made until now" in the debate over financial innovation. I agree. Unfortunately, Salmon makes the same kind of gross over-simplifications that Johnson and Kwak do. The worst one was this:
Securitization absolved lenders from sensible underwriting, since they knew they were just going on onsell that debt anyway.
This is just not true. I know most people think this is true, and that it's some profound insight, but it's not. Securitization doesn't necessarily absolve lenders from sensible underwriting. In theory, if investors in securitizations do the proper due diligence and are sufficiently discriminating, then they wouldn't buy securitizations with bad quality loans in them; lenders who make bad loans wouldn't be able to sell them on, and thus wouldn't be "absolved" from sensible underwriting because they'd have to hold them on their own balance sheets. The weak link in this chain was, again, the rating agencies: investors in securitizations have long outsourced their due diligence to the rating agencies, who got it colossally wrong in 2004-2006. It was the rating agencies that absolved the lenders from sensible underwriting by slapping AAA ratings on securitizations with laughably bad mortgages underlying them. Once it became clear that pretty much any securitization, regardless of the underwriting standards on the underlying loans, could get rated, all bets were off. Conduits—which package together and securitize mortgages—revised their origination guides that they circulate to banks and other loan originators, which essentially gave them the green light to ignore underwriting standards, since the conduit knew it could place virtually any loan in a securitization and still get it rated. Because underwriting standards didn't matter anymore, the mortgage business became all about volume. Independent mortgage lenders like Countrywide and banks like WaMu originated as many loans as humanly possible, confident that they could sell them on to a mortgage conduit. (Of course, Countrywide owned its own conduit, which probably presented absolutely no conflict-of-interest whatsoever. Or something like that.) Far from showing that securitization absolves lenders from sensible underwriting standards, what this shows is that the securitization market of 2004-2006 absolved lenders from sensible underwriting standards. So yes, let's have a serious discussion about the costs/benefits of financial innovation. I'm all for it. But to have that discussion, you have to be willing to not play to the crowd for a few posts. So far, the entire debate over financial innovation seems to have taken place among people with little or no experience in financial markets, and thus little understanding of how certain financial innovations have translated into real-world benefits. Unfortunately, the only defenders of financial innovation have been people like Niall Ferguson, who—let's be honest—is a total joke. Now, I definitely wouldn't characterize myself as a "defender of financial innovation" (though I guess a lot depends on how you define "financial innovation"), but I've been around long enough to know that the last 30 years, contrary to popular belief, have seen plenty of beneficial financial innovations. I've been meaning to write a post about financial innovation for a while, but I obviously haven't had time. In the interest of having a serious discussion of financial innovation though, here are some of the beneficial financial innovations of the last 30 years:
  • Zero-coupon bonds
  • Project finance
  • Treasury STRIPS
  • Medium-term notes
  • Puttable bonds
I'll write a post explaining how these have been beneficial later, but I think the benefits of each of these financial innovations are pretty clear-cut.


Don said...

I'm wondering if the problem with CDOs in the recent crisis was their relative illiquidity. This occurred to me when I was thinking about when I sold my house. It was just before prices took a big plunge in my area. However, I didn't get a lot of offers. This had shocked the realtors I knew. It was pretty clear that houses had been viewed by a number of people as being a liquid asset. I didn't know a lot of people who thought that housing prices could never go down, but I don't think I knew anybody who didn't believe they could quickly sell their house in my area.

I believe that, after Lehman, we had a Calling Run, which features a Flight to Safety. The safety is measured by a govt guarantee and liquidity. If you have assets that are illiquid and not guaranteed by the govt in this situation, those assets are going to get harder to sell and take a huge drop in price. That's the panic that I wanted to avoid when I say that the govt should saved Lehman. Things would have been bad, but a much more orderly process would have avoided the Flight to Quality and the threat of Debt-Deflation.

Perhaps, and this is a question, many investors believed that their CDOs were liquid. Since they were being created in large numbers, the idea was that they would be relatively easy to sell.

At bottom, I find that what we had was a liquidity crisis. So, I don't think that it's the fact that CDOs weren't rated correctly for every possibility, but that they weren't rated correctly for ease of exit. But, as I say, this is just an idea.

Don the libertarian Democrat

M said...

Cars are killing thousands of people every year, but you don`t see anyone out there saying car innovation is a bad thing. You just here about steering innovation to introduce more safety. In order to do that, knowledgeable people discuss the facts, the data and the possibilities and put rules in place that support the right type of innovation.
Somehow in Finance there seems to be a 100% right or wrong discussion on innovation, as you say mainly by people who seem to have very limited knowledge on the subjects discussed. Therefore it is good to see someone like you take the subject on with more insight and a drive to make things better. Wish more people read your blog. And wish you had a little bit more time.

Your Conscience said...

Yeah, you're the best thing since sliced bread, a legend in your own shower. (And even more annoying than I am, which is pretty tough to do)

Sounds like you make a living from securitization and derivatives.

Why don't you go get yourself an honest job?

Anonymous said...

Ok, what were the benefits from those innovations to the real economy? How did they make investment more productive, after fees are removed.

So far you've not made a case, at all.

Philip Crawford said...

Any post that places some blame on the NRSROs is one I like.

A thought I just had while reading this is that financial innovation has clearly lowered the borrowing costs for firms. These entities utilize this low cost capital for profit generating investments and thus they (and society) are better off than they would be with high cost capital and the corresponding lower amounts of investments. (Ignoring the inflexibility caused by having debt.)

Financial innovation for regular people allows us to borrow more to bring forward consumption. Seems less beneficial for society. Or maybe I'm missing something.

Mostly, I just wanted to let you know that I read your blog and very much appreciate you taking the time to write it.

albaz said...

I always enjoy contrarian thinking. It is like science fiction and conspiracy theorizing to me: flights of the imagination which take me on little mind adventures before I return to the real world. e.g., articles like this one.

So, it is not the "innovation" but its marketing that is the evil? Why do I restate the thesis thusly? Because the reason for the deterioration in rating standards was that as long as they were properly rated those gigantic piles of stinking dung (er, innovations) could not be sold to the unwary.

And it was to the unwary: the pension funds, the suckered customers of hedge funds, figuratively: widows and orphans all, that these were now sold by the bucketful.

Nothing happens in a vacuum. All is interrelated. To the point: the rating agencies which you demonize here (and they deserve it as much as anyone) colluded with the creators and purveyors of the renamed swill whether intentionally or otherwise. All were on the same gravy train.

The simple fact is that virtually every derivative, whether they tangentially may provide more or less of a service, is nothing but a gambling device whatever self serving rationalizations are offered in their defense. And every gambling device involves a vigorish in order for it to be worthwhile to the producer thereof.

Bundles of BBB rated mortgages could have been and were sold at a substantial discount. The CDO was structured in such a way as to rationalize an AAA rating for BBB (or worse) bonds using mysterious "genius" calculations to justify their claimed value.

Those and their cognate CDS's (wondrous, innovations) lie now as shaky underpinnings of a slowly (no longer precipitously) collapsing financial system. In a drought even green shoots wither and die for it seems the C of the CDO was a fiction. The collateral was illusory also.

Justifying the flim flam is fun but not really useful.

mattw said...

I agree that in principle a CDO senior tranche can be very secure. I definitely agree that the NRSRO's deserve a huge amount of blame. The question in my mind is: if the ratings had been provided honestly, who were the logical buyers of the equity tranche?

I'm not saying there aren't any, but it isn't clear to me who the natural buyers of that paper are, and that if you paid people enough to assume those risks, that you would have had enough income left over to make the other tranches attractive, and provide some reasonable margin to the securitizer.

If not, this is kind of a useless innovation, since no one would do it if it had to be done honestly.

JCH said...

In the world before securitization, try to imagine what would have happened had the President of the United States conspired with his housing and finance buddies to get 5.5 to 8 million houses built in 6 years for the minority Republicans of the future? His first charge, make it really easy for them to qualify for a mortgage.

To assure a 100-year Neocon reign, would the banking industry finance the homes? I think so.

Greg Hill said...

The risk associated with a bundled set of assets depends on the correlation of the default risks, etc., among the assets in the bundle. Would it be a fair criticism to say that the models which produced the correlation coefficients among assets assumed that the past would be a very good guide to the future? The rub being that we've never experienced a nationwide collapse in housing prices that was not associated with a nationwide depression.

Dale B. Halling said...

Blaming innovation, financial or otherwise, is confusing the tool, instead of the users of the tool. Tools can be used for good or bad purposes, however it is clear that the world economy is better off with more tools - innovation. When the joint stock limited liability company was introduced to the world, it caused two countries’ stock markets to go through speculative bubbles France and England. France went on to forsake financial innovations, while England continued to embrace financial innovations. England’s willingness to embrace financial innovations, is a major reason why England not France was the location of the industrial revolution and the most powerful nation in the world in the 19th century. For more information the history of financial innovation see–-the-medicine-is-worse-than-the-disease-part-1-background/

Wil said...

I do not think the end justifies the means.

In the end, whether ratings agencies are to blame or not, the system collapses and the bailouts commense, the deficit soars and we need to bail out the bail out to pay the interest on the debt until we Zimbabwe along to the North American Union of default.

But it's nice that 1% of the population hedged the collapse - now they can buy a $1,500 hamburger while everyone else starves.

Anonymous said...

"It was the rating agencies that absolved the lenders from sensible underwriting by slapping AAA ratings on securitizations with laughably bad mortgages underlying them."

I think a lot of people have a problem with the idea that just because you could get a conflicted stake-holder to misassign a rating doesn't necessarily absolve anyone from a responsibility for fair dealing. And even if that is technically true, the public wants to change that dynamic.

But your criticisms that the ratings agencies and the customers themselves have blame is well-placed. In fact, why the government wont allow the customers to simply suffer their losses is beyond me. Losing capital that was incorrectly put at risk would be the best long-term market adjustment mechanism that can be employed. To torture our markets into unnatural positions to help the culpable avoid those losses is absurd.

zosima said...

I think Kwak and Johnson understand how CDO's work very well. You link a summary of their work that has been distilled for popular consumption. If you followed their blog, you'd understand that they have well considered reasons for their claims. I'll attempt to explain below.

1. CDOs only significantly decrease risk if the underlying bad investments have low correlation. This correlation was estimated using historical extrapolations with relatively recent data. In retrospect it is obvious that these techniques underestimated long-tail risk of correlation that can occur in financial crisis.

#2 Due diligence on CDOs requires estimating the joint risk of all the investments in the CDO. This is largely equivalent to doing the underwriting on the investments a second time. As the late crisis demonstrated, it can be very difficult to figure out what investments are constituents of a CDO. For example, the Fed couldn't identify the original mortgages in CDOs when it was trying to refinance them. Often details of the financial instrument would be provided by a piece of proprietary software from the CDO originator, which is completely opaque.

#3 As noted in #1 the CDOs failed because of underestimated long-tail risk. Clearly, market signals are only apparent once the CDO begins to fail. Because the failures were correlated, there was no gradual weeding out of bad originators by the market. All the bad originators showed up at once, essentially weeding out the entire market at one time, rather than a few originators at each time.

#4 A rating organization can face a large cost in doing the same underwriting that the originator was supposed to do AND the originator pays the rating organization to rate their investment. These incentives are broken. It provides the rating organization with an incentive to give a good rating and a disincentive to dig too deeply.

#5 The math required to estimate the risk of a CDO is pretty complex, making it difficult for non-quants to estimate risk and very unlikely that the managers will understand the details. Beyond this, everyone was using the same model so they all got the same result. (I suppose this is a second order risk correlation).

#6 Since originators don't actually hold the asset, but instead make their money off of transaction fees, they have an incentive to emphasize quantity over quality, and to minimize the significance of long-tail risk.

Concluding. All of these factors contribute to increasing the risk of CDOs and other "innovative" tools. People talk about innovation as if it is intrinsically good, but this shouldn't be the case in an industry that is in the business of minimizing risk. By definition, new tools have short track records. We can't know if they have skewed incentives, opaque structure, flawed models, hidden correlations, or economic rents.

Yes ratings organizations contributed, but to put the fault only at their feet tells a nice narrative, but it underestimates the complexity and breadth of the market. Ratings organizations are just like any other market member; all of which were fooled by seductive claims to innovation.

zosima said...

Two other arguments from Kwak and Johnson.

#1 An efficient market, a la the efficient market hypothesis, is a zero profit market. The fact that widespread financial innovation increases profit, rather than decreases it, indicates that financial innovations aren't increasing social benefit.

#2 Financial products can serve as a way of differentiating your product from your competitors; effectively branding your product. This results in greater profits at the expense of a smaller consumer surplus.

Note that #2 may explain the paradox of #1. Banks aren't increasing the efficiency of investment allocation, they are branding by creating products that trade short term risk for long tail risk.

Anonymous said...

Thanks for this post. Very much looking forward to the next one.


James A. Donald said...

The "securitization market of 2004-2006" started getting seriously bumpy in 2005 November - at which time people started to notice that the official ratings were not merely a little optimistic, but were totally out of line.

So tell me, why did the rating agencies keep rating everything as AAA, when everyone knew or strongly suspected what worthless crap many of these mortgages were?

anne said...

I agree with you that financial innovation in and of itself is not "bad." That's like saying the X vaccine got pulled because it created serious illness in children who received - we must pull all the YZ vaccines too!

You cannot trash all innovation because some innovation is flawed.

And I agree wholeheartedly that ratings agencies were negligent in in ways that proved exceptionally damaging to the economy.

But a pretty large number of "laughably bad" mortgages had to be handed out before they could be given triple A ratings by the ratings agencies - which means there was a lot of junk peddling going on prior to the realization that that junk was being given a great rating.

That kind of systemic corruption is not just the result of the failure of the ratings agencies. Exacerbated by those failures, yes, most definitely, but not the result of them.

Why do you think the ratings agencies failed so catastrophically? And what do you think can be done to prevent such a failure in the future?

JCH said...

"So tell me, why did the rating agencies keep rating everything as AAA, when everyone knew or strongly suspected what worthless crap many of these mortgages were? ..."

Perhaps this is a secret, but corporations are full of political hacks - operatives. Most of them are Republicans.

The President of the United States ordered that 5.5 million homes be built and sold to minority families by the end of his Presidential term. He ordered that it be easy for them to get financing to buy those homes.

And he got'er done - mission accomplished with just a few rules bent. When people realized how much fee money they could make with liar loans, another 5 million houses glommed onto the bandwagon.

They wanted an ownership society because they believed minorities would switch to the Republican party once they owned their own homes.

Prior to becoming the President, Bush and Rove obsessed about this issue as Texas is one of the states where minority voters will soon be the majority, and that threatened the 100-year reign of the Neocons. These folks wrote books bout this. The printed their plan.

Anonymous said...

I agree with the tenor of your post. However, I don't agree that any tranche of "a CDO with a $100 face value, backed by a pool of BBB-rated mortgage-backed securities" can be deemed "safe" (i.e., truly AAA), especially when the mortgages backing the RMBS are subprime, since the entire underlying BBB pool can conceivably be wiped out. In this case, no level of subordination or overcollateralization will save you.

I would thus contrast RMBS with CDOs. I believe it is quite legitimate to say that a tranche of RMBS backed by subprime mortgages (i.e., crap) can nonetheless be structured to be safe (truly AAA), since it is nearly inconceivable that the entire pool of underlying mortgages will go to zero.

Benjamin Supnik said...

This strikes me as a case of "where theory meets practice."

It is possible to engineer a CDO that is a good idea.

How would we know ahead of time if we got it right though? Perhaps the overcolatoralization is too thin or the credit enhancements attached are not properly represented (think AIG).

If I have a new operating system, and it is still in beta, and it sometimes crashes and destroys all your data, you might be a little bit harsh to say "let's ban this."

But if that operating system was deployed nation-wide and then proceeded to crash and everyone lost their data, you'd expect some strong questions about what went wrong.

With small tech gadgets it's fun to be on the bleeding edge, because the stakes are low. As the current crisis shows, the financial system is nothing like that.

David Harper said...

Great original points and terrific nuance added by zosima ... I find it easy to agree with both

Student said...

The problem is purely in the incentives and signal quality of the rating agency. If they can't be held liable for the quality of their ratings, there's really no risk to them in having risk in your measure of risk. Also, I enjoy playing world conquest board games with little plastic armies with dice and cards.

Anonymous said...

zosima, your comments are not correct:

1) EMH most certainly doesn't say that there are zero profits. Stick your money in a T-bills and you make a profit. Stick your money in an index fund. Furthermore, there is a consequence of the random walk that an excess of the money will go to a few - purely by luck.

2)The correlation risk is not from correlations of the underlying but rather because they are in a CDO. Kwak and Johnson get cause and effect round the wrong way. When a company owns a CDO and has to sell he marks down all the other similar CDOs causing them to be worth less. The actual economic decline in the CDOs is irrelevent especially when company are getting literally killed in the press for holding "toxic assets".

3) this leads into your follow up comment. The CDOs don't "fail", what they do is get marked down dramatically as everyone rushes for liquidity. CDO down in **price**, T-bills up. The underlying defaults, correlations etc are irrelevent, price is set by panic sellers not the payouts.

4) In ratings it is not the originator that pays it is the guy who packages up the underlying assets who pays for the tranches of the CDO to be rated and during the boom, there was such a high demand for raw material for CDOs that originators simply could not write enough mortgages quickly enough - hence the synthetic CDOs. It was a demand driven expansion not that the originators had excess capacity to securitise, not even that they had enough people wanting to borrow.

4) The "they are so complex to value" is nonsense. No one thinks of equities as "to complex to value" yet a Citibank stock is clearly vastly more complex than any CDO - and i would argue impossible to value - but the point is that there is less liquidity risk with an equity than a custom CDO. I can slice off a holding of equities to far more people than i can a CDO.

Needless to say given the assumptions are so faulty that their conclusions would be so far off.

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