The "originate to default model" and its unsavoury characters

I’ve spent enough time in banks and a brief but intense stint during Enron’s twilight to understand the huge unravelling of the farce cum accident-waiting–to-happen of the current banking crisis. Commercial banking has always been regarded as the backwater of financial services until some bright investment bankers decided that they were going to turn a traditional and sleepy banking model into a money-making machine.

Historically, commercial bankers had a deep and ingrained sense of credit risk derived from the knowledge that they were investing other people’s money; usually deposits. As a result, loans were carefully monitored and handed out cautiously. Leverage was treated as a dangerous and addictive treatment and, as such, was to be administered sparingly. Assets were booked on the balance sheet and kept to maturity. If a loan went bad, the banker was undoubtedly affected. That is, until the “i- bankers” arrived and decided that through the use of debt capital markets, financial institutions could offload this exposure to unsuspecting investors. Thus the “originate to distribute” model was born...

The new operating model consisted in hiring aggressive, young and naïve bankers (akin to sales reps) whose sole role was to push money out of the door. This role was supported by a clique of product specialist whose letimotif was to distribute the rubbish that was originated to unsuspecting investors. These product specialists came in different flavours: one was the syndication specialist who usually onsold the rubbish to less sophisticated banking institutions and the other was the debt capital markets specialist who created securities backed by rubbish as collateral. Both systems created moral hazard by decoupling the credit risk from its associated rewards. Banks found they could engage in almost risk-free lending.

The process described above created a “virtuous” circle in which extremes soon started to flourish. Originators became more naïve, loan documentation became weaker, credit spreads fell lower and the borrower held all the negotiating power. The approach across banks was: “Who cares? We’re not keeping this crap anyway...” Meanwhile, borrowers had a field day, low income households went on a spending spree supported by debt secured on credit-bubble inflated assets, private equity firms added “value” through leverage, the financial services sector had a field day... and in ten years the “originate to distribute” model mutated into the “originate to default” model. Now that the loans have been originated the time has arrived for them to default. Who’s first in line? (i) Countries: Spain, USA, UK, Ireland and China as the big beneficiary of spending but also a major creditor; (ii) Sectors: Real Estate, Automobile, Infrastructure, Financial Services and any sector depending on high leverage or cheap financing.

Who are the industry characters that have flourished in this environment? I could name a few but I am sure it is not necessary. If you are in the business you will recognise them. Ego-driven, mediocre, social psychopaths, good communicators, with an unrelentless focus on short-term earnings and a lack of ethical or moral standards to constrain them; fuelled by compensation mechanisms which reward today’s income but do not penalise for disaster tomorrow. The new “masters of the universe” seem in hindsight to have been “the masters of disaster”.. Few people, including myself I’m afraid, had the courage to stand up to these bullies while the going was good. It’s high time they were let go...

For an interesting read try: http://www.ft.com/cms/s/0/d3321cc4-ffef-11dc-825a-000077b07658.html