Home Finance The Transformation of the Traditional Originate-to-Distribute Model in Financial Markets

The Transformation of the Traditional Originate-to-Distribute Model in Financial Markets

by internationalbanker

 

 

 

 

By Zhiguo He, Professor of Finance, Graduate School of Business, Stanford University; Sheila Jiang, Assistant Professor of Finance, and Douglas Xu, Assistant Professor of Finance, Warrington College of Business, University of Florida

 

Under the originate-to-distribute (OTD) model, the originator of loans sells them to various third parties after the loan-origination process. Financial securities issued in the structured-finance market are good examples of securities issued under the OTD model. For instance, mortgage-backed securities (MBS) are securities backed by mortgage loans originated by banks. One feature of the traditional OTD model is that the originators of the underlying collaterals directly issue the securities and sell them to secondary-market investors.

In recent years, a group of intermediaries have shown up in the traditional structured-finance market to issue asset-backed securities (ABS) backed by loans they did not originate. We call this model the intermediated originate-to-distribute (intermediated OTD) model. The collateralized loan obligation (CLO) is an example of the intermediated OTD model. In a CLO, the CLO manager purchases slices of corporate loans originated by commercial banks and packages them into bond-like securities. As another example, in the non-traditional asset-backed securities market (also known as the esoteric ABS market), under the traditional OTD model, timeshare companies such as Hilton Grand Vacations Inc. would directly issue the asset-backed securities backed by the timeshare receivables they originated. More recently, under the intermediated OTD model, asset-management companies, such as BlackRock, Inc., issue timeshare ABS backed by receivables generated by traditional timeshare companies, such as Hilton Grand Vacations Inc.

In the remainder of this article, we call these asset-management companies “financial intermediaries” in the ABS market, and we call the originators of the underlying claims or receivables, such as Hilton Grand Vacations Inc., the “originators” of the underlying collaterals.

The burgeoning phenomenon of intermediated on-time delivery is significant and attention-grabbing. The total volume of CLO issuances increased from $5.1 billion in 2009 to $403 billion in 2021. Among all types of asset-backed securities, including CMBS (commercial mortgage-backed securities) and RMBS (residential mortgage-backed securities), the percentage of CLO as a share of the total volume of newly issued asset-backed securities increased from 3.4 percent to 36.9 percent. CLO managers are typically asset-management companies. Importantly, these CLO managers are independent from traditional commercial banks or investment banks, which are the originators of the CLOs’ underlying collaterals. The figure below shows the total volume of CLO issuances by independent CLO managers and CLO managers that are subsidiaries of commercial banks or investment banks. Only 3 percent of the CLO deals after 2010 were issued by CLO managers that are subsidiaries of commercial banks or investment banks. The tremendous growth of CLOs and the fact that more CLO managers are financial intermediaries independent from the originators highlight the importance of intermediated OTD in corporate-loan securitization (corporate loans are fundamentally different from mortgage loans, which are more standardized and sold to government-sponsored enterprises).

Similarly, the burgeoning trend of intermediated OTD is rising in the non-traditional, or esoteric, ABS market. The total volume of esoteric ABS issuance increased from $12.6 billion to $103.3 billion in 2021. As shown in the figure below, the proportion of ABS deals issued by financial intermediaries (independent asset-management companies that are not the originators of the underlying receivables of the ABS—an example is BlackRock) increased from around 5 percent in 2009 to more than 20 percent in 2021. Whole Business Securitization (WBS), Specialty Finance, Insurance, Aircraft Receivables and Timeshare are the top five categories of underlying collateral from which financial intermediaries actively issue asset-backed securities in the esoteric ABS market. With the growing participation of financial intermediaries, the diversity of the underlying collaterals of esoteric ABS also grew quickly. In 2008, there were only about five categories of underlying collaterals; by 2021, the number of different categories of collaterals had reached 20. Compared to ABS deals issued by the originators of the underlying collaterals, esoteric ABS deals issued by financial intermediaries have smaller numbers of tranches, longer weighted average lives, lower collateral enhancements and lower coupon rates. These facts indicate that deals issued by financial intermediaries are less information-sensitive and can be traded at higher prices.

What economics justifies the recent emergence of these middlemen in traditional originate-to-distribute processes? Given that information asymmetry has been regarded as the most prominent friction in originate-to-distribute processes, it is not straightforward that intermediating such processes will resolve the friction. After all, if investors were to trade with someone who has superior information, there is no obvious explanation for why informed intermediaries should be more “credible” sellers than the originators themselves.

In He, Jiang and Xu (2024), a theory is proposed to shed light on the economics behind the operation of the intermediated originate-to-distribute model. In this model, originators subject to idiosyncratic-type realizations produce assets that they then bring to an imperfectly liquid asset market to sell to uninformed buyers to reduce the costly retention of their created assets. When originators themselves perform such an asset sale, a commitment issue—originators cannot commit to refrain from producing “lemons” after they get a “bad type” realization—leads to welfare losses in the economy. This is because the bad type of originators cannot discipline themselves from taking advantage of investors’ inability to discern the types of assets brought in for sale in the asset market. This, in turn, keeps the assets’ selling prices low and hence limits the production scale for the “good type” of originators.

Somewhat surprisingly, it has been shown that the operations of informed intermediaries can improve economic efficiency in this originate-to-distribute system, even though these intermediaries are also subject to similar agency problems (i.e., purchasing lemons at a presumably cheap price and then selling them at the pooling price) when they have private information regarding the types of purchased assets that uninformed buyers cannot discern. Unlike the originators with a bad type of realization, informed intermediaries have the option not to place lemons on their balance sheets. In fact, it turns out that in the equilibrium that emerges within an intermediated originate-to-distribute economy, informed intermediaries can commit to purchasing only assets produced by good-type originators. Through such “cherry picking” in their asset purchasing, the operations of intermediaries thus effectively improve the asset quality in the asset market, leading to higher asset selling prices and hence facilitating the origination of good assets in the economy.

 

 

ABOUT THE AUTHORS
Zhiguo He is the James Irvin Miller Professor of Finance at the Graduate School of Business, Stanford University. He is a Financial Economist whose expertise covers financial markets, financial institutions and macroeconomics broadly. Before joining Stanford GSB, he was on the faculty of the University of Chicago Booth School of Business, where he received tenure in 2015 and led Becker Friedman Institute China.

Sheila Jiang is an Assistant Professor of Finance at Warrington College of Business, University of Florida. Her main research interest is the empirical study of banking and corporate finance. She received her B.S. with First-Class Honours in Mathematics and Economics from the University of Hong Kong and her Ph.D. in Economics from the University of Chicago.

Douglas Xu is an Assistant Professor of Finance at Warrington College of Business, University of Florida. He researches corporate finance, banking, contract theory and applied microeconomics. He received his Ph.D. in Financial Economics from the Department of Economics at the University of Chicago Booth School of Business.

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