How Originate-to-Distribute Brought Down Wachovia

Zubin reckons there's reason to believe the originate-to-distribute business model wasn't responsible for the subprime mortgage crisis. He might be right. But I'm not at all convinced by some of his arguments. Consider this one:

If you believe that incentives were misaligned, then you'd have to think that subprime originators would be decently protected when loans soured. But as the chart on this post shows, subprime lenders like Countrywide, Ameriquest, and Saxon were among those who bled the most.

I believe that incentives were misaligned, but I don't believe that means originators were protected when loans soured. Instead, I believe that hundreds of small operators set themselves up as a limited-liability business which made lots of easy money in good times, and then simply shut down in bad times -- they had enormous upside, and strictly-limited downside.

Now I'm not talking specifically about Countrywide here. Countrywide was a big company which was built for permanence. But cast your mind back to 2006, when the implode-o-meter was just getting started. Merit Financial closed in the spring; by December, much larger concerns like Ownit were closing.

But notice what happened with Ownit: its owners, including Merrill Lynch, simply stopped providing it with money, and you can't originate mortgages if you don't have wholesale money to lend. So Ownit closed and its employees were laid off. But its profits over the course of its prior existence were still in the pockets of its former owners; once Ownit closed, they had no liability any more.

Closing Ownit was an easy decision: if it had stuck around much longer, it would have been forced to buy back a bunch of loans which never generated any payments at all: those are known as first-payment defaults, and investors have the right to put them back to the originator. If the originator exists.

According to Zubin, the existence of that put option is evidence that incentives weren't misaligned. But in most cases (and Countrywide, here, is a big exception), the originators never stuck around long enough to be seriously damaged by an influx of first payment defaults.

After all, as long as home prices were soaring and everybody was making money, very few people defaulted on their first payments. The minute that changed, the originators started closing. They might have taken a modest loss in their final quarter, but they were always in the moving rather than the storage business: they never had much in the way of assets. Past profits, after all, had been dividended up to the owners, since there was no need to reinvest them in the business.

Essentially what happened is that many businessmen (and for some reason they were nearly always men) founded companies which would make them millions of dollars a year for some unknown period of time. When the good times ended, they ended -- but they were fun and profitable while they lasted.

Now consider the position of a much bigger company like Countrywide, faced with all this new competition. In order to maintain market share and profitability, it has to adopt the same business model of the fly-by-night operators. But the difference is that Countrywide did have assets and did have equity, and therefore was at risk of suffering the substantial losses which eventually transpired.

Eventually, big banks started wanting to get in on the game as well -- hence such ill-fated deals as Wachovia's acquisition of Golden West, which will go down in history as a classic case of suicide-by-acquisition. But all of these deals can be considered a special case of Gresham's Law, which states that bad money drives out good. The banks were using good money, the fly-by-nights were using bad money, and the bad money, as it always does, won.

And the bad money was precisely the money which relied for its existence on the originate-to-distribute model.

So if you're looking for misaligned incentives, don't look at Wachovia or Countrywide. Look instead at Merit, Ownit, and their ilk. If you still think that incentives are aligned, then I'll be much more convinced.