Managers of a functionally organized firm must coordinate the activities of each division. Otherwise, the divisions may end up working at cross purposes.
The incentive conflict between bank deposit and lending divisions is a classic example. The S&L crisis of the early 1980's was caused, in part, by the behavior of S&L's which borrowed short (deposits) and lent long (home mortgages). When interest rates skyrocketed in the early 1980's, S&L borrowing costs increased dramatically as depositors demanded higher rates, but revenue did not change on the 30-year, fixed-rate mortgages. Good managers would recognize the mismatch between deposit and loan maturities and use financial markets to offload some of the risk.
It seems as if something similar may be going on in today's banks. The loan originators and (mortgage brokers) are compensated mainly on volume, but not the quality of the loans they make. This leads to risky loans that may not be recognized as risky until housing prices start falling, and borrowers find it more profitable to forfeit the house to the bank. Again, good managers will recognize the incentive conflict between loan origination and servicing, and try to control it.
In an earlier post, we suggested that investors ignored risk in search of higher returns as they drove risk premia on all kinds of exotic and risky investments down to historic lows. It may be that functional specialization has been partly responsible for the failure of subprime lenders to recognize risk. When loan originators make loans that no investor wants to fund, lenders go bankrupt.
Divide each originator's loan volume by the weighted average credit score of the borrowers before paying out his or her bonus. You will need to increase the bonus percentage to offset this systematic discount.
ReplyDeleteOr, more likely, lobby congressional democrats to subsidize credit risks by transferring wealth to homeowners through the tax code.
This has nothing to do with functionally organized banks. The entire "Credit Crisis" is being driven by irrational market behavior. Over a 12 month time frame--if the investor purchasing the mortage and liquidating as necessary is willing to be patient--they can get their money back based on home value and still diversify their risks sufficiently.
ReplyDeleteIf the government will just get out of the way with their interest rate caps (ex. TN with their second mortgage rate caps) in their attempts to protect consumers who should be in a buyer beware stance before moving on purchasing a home then the market will correct itself on its own.
Fear of declining equity value is not a significant problem from a statistical standpoint over time. Nobody is creating more land now adays while we are creating more people who demand that land.
All the perceived crisis is doing is creating more opportunity for those who were prepared to buy at deep discounts off of the values of the mortgages.
Originators come and originators go. The strong will survive and those individuals who walk away are still going to leave land behind them that can be resold for a profit along with the interest return that the investor already earned on previous payments.
The functional division misaligns the incentives and goals of loan originators and investors, but if government intervention prevents either party from bearing the penalty for bad decisions, have we really changed the structural flaws that enabled this situation?
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ReplyDelete