June 21, 2009

How The Banks Lost Their Way


I have been wondering how an industry could be so stupid as to make such poor loans and accept such unbelievable risk. How so many good minds could not realize the magnitude of the danger.

Then I came across a paper written by a University of Michigan school of business professor, Amiyatosh K. Purnanandam. And he made it all come clear...

The Originate to Distribute (OTD) Model of Lending

This is the business model that became popular and is the reason why so many loans were made that collapsed and with it our economic health.

The lender, a bank or mortgage banker, originates a loan with the full intention of selling it to third party investors. It made sense. It was a way to create loan volume. The institution didnt have to hold the loan for 10, 20 or 30 years and so it became popular method of credit and liquidity and risk-management.

It all seemed good. Lenders could resell their loans and get back cash to lend again and they thought that by reselling packaged or securitzed loans, they were off loading default risk. Seemed reasonable, responsible and good business.

Bad Idea

Here I quote the professor: As the lending practice shifts from the originate-to-hold to originate-to-distribute model, it begins to interfere with the originating banks' ex-ante screening and ex-post monitoring incentives.

Knowing that they were going to make loans they had no intention of owning, they got lax ( kind word). If you know you wont be holding the loan and therefore are not going to feel the consequences of a bad business decision, why care. In other words, they had no skin in the game!

Once this started to fall apart, the secondary mortgage market shut down. The originating lenders could no longer sell their mortgages. Investors started to realize that the lenders had little incentive to screen as if it was their own money and even less incentive to monitor the loans they made.

Securitized mortgages were riddled with inferior loans and no one could tell good from bad. The rating systems were suspect and markets, which are built on trust, just evaporated. Game up.
* Flicker photo thanks to True Scot

Howard Bell


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