Explain the way the originate-to-distribute model of banking operates and discuss what it gains and what it costs.
The idea
In the originate-to-distribute model a bank makes loans, typically mortgages, and then sells them to investors instead of holding them to maturity. It often pools them in a special purpose vehicle that issues asset-backed securities. The gains are capital relief, since sold loans no longer need capital, new funding that can be recycled into more lending, fee income and the spreading of credit risk across many investors. The costs are weaker incentives to screen borrowers, because the originator keeps little of the loss. They also include less transparency about the underlying credit quality, dependence on rating agencies and on securitisation markets staying open, and implicit support, where the bank has to take assets back in a crisis. These features contributed to the 2007-09 crisis, and the usual response is to require the originator to retain a share of the risk. Exam point: capital relief is real only if the risk has truly been transferred.
A practice question
In the originate-to-distribute model, a bank:
- Makes loans funded by deposits and holds them on its own balance sheet until they mature.Why not: This is the traditional originate-to-hold model.
- Makes loans and sells them on, often by securitisation, instead of holding them to maturity. - correct
- Sells its own shares to investors to raise the capital it needs to originate more loans.Why not: This is equity issuance, not distribution of loans.
- Buys loans made by other banks and holds them to maturity to earn the interest spread.Why not: This is portfolio purchasing, not originating and distributing.
Originate-to-distribute means that the bank originates loans, packages them (for example in a special purpose vehicle issuing asset-backed securities) and sells the risk to investors.
A harder one
Which feature of the originate-to-distribute model most directly weakens the originator's incentive to screen borrowers?
- Securitised pools are diversified across a large number of borrowers and regions.Why not: Diversification affects pool risk but not the originator's incentive to screen.
- Investors receive the loan cash flows through a special purpose vehicle.Why not: The legal structure does not itself weaken screening.
- The originator relies on customer deposits to fund its new loans.Why not: Deposit funding is part of originate-to-hold banking, not a weakness of this model.
- The originator sells the loans and so keeps little or none of the credit risk. - correct
If the loss falls on the investors who buy the loans, the originator's reward depends on volume, not quality: the classic moral hazard in this model.
The hardest tier
A bank can originate USD 200 million of loans to weak borrowers. It earns an upfront fee of 1.0%; the present value of the net interest margin is 1.5% of principal, and the present value of expected credit losses is 3.0%. If it holds the loans, expected profit is negative. If it instead sells them at par immediately, keeping only the fee, which statement is correct?
- Holding earns USD 5.0 million and selling earns USD 2.0 million, so the bank prefers to hold.Why not: Ignores the expected credit loss when valuing the held loans.
- Holding loses USD 3.0 million and selling earns USD 2.0 million, so the bank still prefers to sell.Why not: Leaves the 1.0% fee out of the hold-to-maturity calculation.
- Holding loses USD 1.0 million and selling earns USD 5.0 million, so it pays to originate.Why not: Assumes the bank keeps the interest margin after selling the loans at par.
- Holding loses USD 1.0 million, but selling earns USD 2.0 million, so it pays to originate. - correct
Hold: 200 x (1.0% + 1.5% - 3.0%) = -1.0 million, so the bank would decline the loans. Sell: only the 2.0 million fee is kept and the buyers bear the loss. Distribution turns an unprofitable loan into a profitable one, which is the incentive problem.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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