Saturday, January 26, 2008

Originate-to-distribute: The origin of it all

Let there be banks! And let there be sleepy regulators and complacent credit rating agencies. Place these in a pot where a strong global economic environment is brewing an extraordinary appetite for risk. Add a touch of financial imagination, fuel it with greed. And there was chaos…

Trying to pinpoint the one single factor behind our most recent global financial mess is kind of ambitious, so I won’t go down that route. What I want to do is throw light on a term that has been in fashion since last summer, and which by all counts deserves one of the top spots in the what-went-wrong list: “Originate-to-distribute.” So let there be light!

Simply put, originate-to-distribute (as opposed to originate-to-hold) is an innovative process that allows banks to expand their lending business (i.e. originate more loans) without violating the lending limits placed by regulators. The latter are there to prevent excessive risk-taking. But let’s go back a step.

On banks, loans and cushions: Think of a bank as a bunch of assets and liabilities. Forget about the grandiose buildings, the revolving doors or the smiley receptionists “striving to serve you best.” What makes a bank a bank is that it borrows money from you and me (our deposits) and lends it on to... yes, you and me (a mortgage or auto loan) or to others, like the government or private businesses. We’ll call the loans the bank’s assets and the deposits its liabilities.

A bank has another type of liability: Equity capital. This is the money that the shareholders put in initially, to start up the business. Like any business, if the bank turns out to be profitable, the capital will grow, and the shareholders will reap the benefits. That’s only fair—it’s these guys who took the risk in the first place. Of course these guys will also take the first hit if the bank ends up making losses—such as, for example, those that arise when a bunch of “subprime” borrowers default on their mortgages. The equity capital is therefore a cushion that protects depositors from losing money when a bank makes losses. This is why regulators require banks to have a minimum amount of equity capital, depending on how big and how risky their loan portfolio is.

Pass the parcel: Then came innovation. Banks found a way to keep on issuing new loans to customers without having to expand their capital (which can be expensive). Let’s call that "passing the parcel." One way to do it is sell on these new loans to investors, from pension funds to hedge funds. Another way is to offload the loans to separate entities the banks created for that purpose: The now-famous SIVs, or “Structured Investment Vehicles”, quite distinct from “SUVs”—another household name. With the loans offloaded, banks now had free room to issue even more loans. In fact, the incentive was for riskier, more “exotic” loans (let’s call these “trash”), since these brought higher fees to the originating bank.

Rolling over, and under: So what about those SIVs? Where did they find the money to fund all these loans they found themselves with? Well, they issued debt, short-term debt. Let’s call that “dangerous.” That’s because every 3 to 6 months, you have to convince your lenders to keep rolling-over your debt. And lenders can be moody. So to ensure that the SIVs can continue to function smoothly, some of the originating banks agreed to provide liquidity support during emergencies. This could either be a loan—to help if, say, the original lenders demanded their money there and then—or the promise to buy back some of the junk the bank dumped in the SIV in the first place.

And it was so: Subprime borrowers went bust; followed by some hedge funds investing in subprime mortgages. Next came worries that SIVs owning subprime mortgages will go bust too. So their lenders pulled the plug; and…boomerang! The originating banks are called to collect the pieces.

Sounds grim? I admit I am all for innovation, including the originate-to-distribute variety. It is better for a bank to get rid of unwanted risky loans and sell them to those who have the stomach for it... and the capacity to understand it! Implementation was the problem.

Due diligence: When banks offload the loans from their portfolios, they can be less diligent about assessing how risky these loans are. Especially when the more loans they issue, the more fees they make, so the focus is on volume instead of quality. The situation becomes worse since whatever information is collected by the banks may often not be passed on to the SIVs; let alone to the lenders of the SIVs. So these guys have less than ideal understanding of what risks they take.

The panic of the clueless: The other problem is transparency. With banks having “distributed” the risks, nobody knew exactly who had ended up being exposed to these loans. So when the meltdown began, lenders of various SIVs and financial institutions pulled out in panic, prompting a domino effect. This ongoing uncertainty is partly behind the extremely volatile markets that we are seeing as recently as last week.

Back to those cushions: But it’s not just Wall Street that’s suffering. Main Street will also suffer, as banks curtail their lending to deal with the double hit they face: First, the losses on the subprime junk they did keep in their books; and those on the junk they had offloaded and they now have to bring back “home.” Both work to bring their equity capital closer to the minimum they are required to have. So new lending will suffer, at least until the scale of the losses is clarified.

It took a while... But at the end of the day, markets saw the mess. And what they saw was not so good!

Glossary: Originate-to-distribute, minimum capital requirements, pass the parcel, debt rollover, SIVs, SUVs

Interesting links:

Ten key words to make sense of the crisis

Explaining the financial crisis


Anonymous said...


You write very well in describing the roots of the economic crises plaguing the finals days of the House of Bush, but inquiring minds want to know what it all means. The world's biggest money manager, Bill Gross over at PIMCO, has estimated that there could be trillions more in crap out there (out of hundreds of trillions in derivatives). The SWFs (not single white fema1es!) would have to take over our banks (rather than throwing them a lifeline) if this is true. Oh sage philosopher and bond girl, are we turning the corner with the newest 50 basis point cut or are we heading for a cliff? Where should I put my hard earned dollars and pounds (I hold both)? I long for you wisdom...

Chevelle said...

Ha! You fell into the trap.. you’re asking an economist to predict the future! When our forte really lies in “right-hand-left-hand” reasoning. But I will still indulge, under my capacity as… errrr.. a single white female!

Ben’s 50bp cut was a brave move. Now whether it works will depend on how well lubricated the so-called “transmission mechanism” is: How fast the benefits of the rate cut can be “transmitted” to the rest of the economy. And with banks at the core of this mechanism, I'd say we have a problem.
This is how it should work: Rate cuts by the Fed should translate (to some degree) to rate cuts on car loans, consumer loans, etc etc, making people want to borrow more to buy more stuff… “Made in America” stuff. And so the economy recovers.
This is all good, provided banks can respond to the higher demand for loans. But if they are forced to bring back to their balance sheets all the junk they had offloaded to the SIVs in recent years, and with more losses possibly in the offing, their equity capital may be too little, so they won’t be able to lend much more.

So hang on in there because this will take some time. And as an economist I can assure you one thing: It will take longer than it does to say “bp.”

Matt said...


Thanks for your prompt reply! I am a bit confused though.

What trap did I fall into?

You are a physicist and a bond girl. Surely two of the most predictable professions. I would faint were a book I let go of not to drop and even more so were a bond girl not to sleep with 007! Why can't you also predict the future?

I am hanging in there but would like some foresight, which is rare, as opposed to hindsight, which is plentiful and difficult to find credible...


Chevelle said...

I hate to tell you.. If you’re up in the moon and let go of a book, it will drift away. More importantly, there were indeed some bond girls who never made it to 007’s bed… despite his irresistibility! Tilly Masterson, Mrs Moneypenney and the uber-hot Plenty O’Toole among them. (Yes, me too in case you were about to ask!) However good our models may be, shit happens, thugs stop you from sleeping with Bond, and historic correlations between different securities break down. Economists will be the first to acknowledge that.

Matt said...

Point taken about the Bond girls. I guess you were one of the few to escape the grasp...

As for the moon, well, it does have a gravitational field (which is where waves come from, after all). Not as strong as our own, of course, as it's a smaller mass, but it would pull the book down (though the book would weigh less than on earth)... See here for a primer:

You'd have to go to outer space beyond the moon's gravitational field for the book to escape!

Finally, I appreciate your humility on the limits of models... The agents will carry on doing their thing regardless, alas...

Anonymous said...
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Anonymous said...


Beautifully, I am an Finance student from University of Phoenix, started with-no clue on Finance and your postings are helping me translate words. So, you go White Girl.. keep representing the Power equal Knowledge to those like me who have no clue of these terms.

bmpharmacy said...

This is all good, provided banks can respond to the higher demand for loans. But if they are forced to bring back to their balance sheets all the junk they had offloaded to the SIVs in recent years,

Chastity said...


Ark Ronny said...

Great post... very simple way of explaining hard stuff.. thank you for sharing!