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Purnanandam, Amiyatosh
  Amiyatosh Purnanandam

Bad Loans, Suffering Banks

6/8/2009 --

Research shows link between mortgage securitization levels and financial distress.

ANN ARBOR, Mich. — Investors and regulators continue to sort out the mess from the subprime mortgage meltdown that helped freeze credit markets and shrink the economy. The true health of some banks is still in question due to the unknown value of assets on their balance sheets, and regulators are looking for ways to prevent another crisis.

Research by Ross professor Amiyatosh Purnanandam on banks and their use of the originate-to-distribute (OTD) loan model — in which mortgages are sold to investors — can serve as a guide for the market and regulators.

Purnanandam's analysis shows that the more a bank participated in the OTD market before the 2007 collapse, the larger its mortgage asset charge-offs and defaults after the disruption. When the market for mortgage loans collapsed, these banks were forced to carry the troubled mortgages on their balance sheets. The research also shows higher foreclosure rates for OTD mortgages than those mortgages kept by the originators.

The higher default rate of OTD mortgages is not explained away by differences in the geographical location of the property. Together, the results support the argument that it wasn't just an economic slowdown that caused the subprime mortgage failure. Purnanandam points to an "incentive problem" where banks were not as discerning about borrowers if the mortgage was to be sold.

"The basic premise is that there was this perverse incentive," says Purnanandam, the Bank One Corporation Assistant Professor of Finance. "The screening came down, and the banks were willing to lend to folks they otherwise would not have. We find a systematic pattern in that the banks that were originating and selling their mortgages are suffering disproportionately more."

Purnanandam's paper, "Originate-To-Distribute Model and the Subprime Mortgage Crisis," uses data from FDIC-insured banks, which file quarterly reports.

The data also shows that banks with lower capitalization, and ones that relied less on demand deposits and more on the financial markets, were more likely to originate low-quality loans. Banks primarily funded by demand deposits — savings and checking accounts, for example — did not originate excessively inferior OTD loans.

Purnanandam thinks that's evidence in support of the incentive problem. If banks with a lower capital base wrote more OTD loans simply because they were hitting constraints, the performance of their loans shouldn't be any worse than others. But that's not what the numbers show.

"If it were simply a good risk-management situation, then the lower-capital banks should have even better OTD loans because they know they would have to turn down credit-worthy borrowers if they had to carry the loan on their books," Purnanandam says. "But I'm not finding that. The OTD loans they were selling were of even worse quality."

The research suggests that regulators looking to prevent a repeat of the subprime meltdown should look at how a bank is funded, and not just its actions. Not all OTD loans are created equal.

"From a regulatory viewpoint, you should try to understand what motivated banks to do this," he says. "And I find that if they had a lot of debt, it motivated these banks to go for this activity. So you should pay careful attention to how the bank is funded, because there is a non-trivial link between how the bank is funded and what it is doing."

Purnanandam also suggests that regulators might want to require banks to keep a portion of a loan it originates. The OTD market should be allowed to continue, but originators should have some skin in the game, he says.

For investors, the study shows they also should look hard at the capital structure and liabilities of a bank taking mortgage loans to market, since the quality of mortgage loans depends on those factors in a predictable way.

"In an information-sensitive market, the issuer's capital position and liability structure have important implications for the pricing of the assets in the secondary market," Purnanandam says.

—Terry Kosdrosky

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847,