Maybe it’s the Californian in me, but when it comes to the environment, I’m not ashamed to say that I’m your basic nature-loving tree-hugger. It’s a badge I wear with pride. Suppose, for instance, that it comes down to a choice between building a freeway that potentially endangers a species as opposed to spending a little more time and money to build a tunnel to protect the species’ habitat. For me, that’s hardly a difficult call. Put me down for the tunnel every time.

I don’t roll my eyes when someone produces a new spotted tree frog in an effort to prevent someone from turning a rolling pasture into a convenience store or gas station. To me, animals are worth saving and removing even the smallest species can have a significant effect worldwide. Nope, I am an unabashed champion of the environment over progress, animal rights over jobs, and the San Francisco garter snake over, dare I say, yet another Starbucks closer to my home.

Well, I was. Until I watched a recent National Geographic television show. Let me explain.

The program was about a fascinating discovery of the fossilized skeleton of a crocodile that was more than 40 feet long and that weighed 10 tons. The animal lived a mere 110 million years ago and swam through the large rivers and lakes, pouncing on brontosaurs at river’s edge, dragging them into the water, and eating them after they stopped squirming. The researchers carefully reconstructed the animal by analyzing the fossilized skeleton; the model they created it required an entire warehouse.

Seeing all of this on screen (HD is not for the weak of heart sometimes) and understanding how today’s alligators and crocodiles can behave – well, I’ve decided that extinction isn’t always a bad thing. If that beast roamed our earth today, no one would be safe anywhere near fresh water. You clearly couldn’t run fast enough or shoot accurately enough to avoid a grisly demise. This was no mere lion or rhino that you could view safely from your car or at the zoo. The automobile steel, engine, and tires would pass through this super-croc’s digestive tract in just a few days without requiring so much as an antacid. Yes, in light of this prehistoric discovery, I am now firmly in favor of eradicating certain species entirely from the face of the earth.
The same is true of species in the home-lending industry.

Like animals, there will always be business species that, because of environmental changes in home lending (whether manmade through regulation or through free-market equilibrium), will simply die out or be obliterated. Some will be sorely missed. Others – like the giant super-croc – not so much. And that’s just fine with me. Which business species should go? Well here is my quick, back-of-the-envelope list:

1. Antiquated Commission Structures – In most lending organizations today, brokers receive commissions based on the size of the loan. Whether the loan gets paid off immediately or ends up in default - there is no downside to the broker who assumes no risk. The bank (or secondary-market investor) takes all of the liability with no short-term upside. With home equity lending, the loan itself might never even be funded - but the commission is still paid. This is a dinosaur that must die. According the Bureau of Labor Statistics, the number of employed mortgage brokers has decreased 30 percent year-over-year in 2007 and is continuing a rapid decline that is directly attributable to today’s environment. I doubt the broker industry will ever come back the same way again.
2. Under-Capitalized Lenders with No Skin in the Game - I remember visiting a subprime lender in Southern California where there were literally 15 brand new Ferraris (mostly red, some yellow) parked in front that belonged to company executives. Don’t get me wrong – you won’t find a more zealous defender of capitalism than me. Everyone deserves the car of his dreams and Reagan trickle-down economics demonstrates clearly that thousands of people in Italy and the U.S. are now better off because of those cars in the parking lot that day. Lenders like this one get capital – enough to originate a pool of loans – and then immediately sell those loans to investors on the back end, raise more money, and do it again. Like the brokers, they carry none of the risk. If the loans they originate and sell are called for whatever reason and the investor demands a buy-back, those executives simply close the company and start a new one. Lenders with nothing on the balance sheet are becoming extinct. The Web site www.ml-implode.com has the details on nearly 250 lending operations that have died out since 2006. Most of those are the kind of companies with 15 Ferraris out front. I suspect we’ll see more extinction here.
3. Over-Distribution of Risk - The market exists for one purpose: to spread risk. A stock price is set, not on the financials of the company or characteristics of the security instrument today, but on the present value of its future cash flows, discounted by the risk of achieving those cash flows. In healthy markets, long-term risk is clearly visible. It is discussed and argued by informed experts, market-watchers, and investors – people who make their livelihoods analyzing someone else’s propensity to succeed. But as the market for mortgage-related securities matured, instrument upon instrument was created and sold and resold - to a point where the real underlying risk of the individual loan was lost or misunderstood. Former chairman of the Federal Reserve, Alan Greenspan nurtured this distribution of risk as a way to strengthen the market and ward off inflation. It was a smart play, but it went too far. It reached a point where investors were trading mortgages that neither party — the seller or the buyer – understood. Even the agencies that rated the risk didn’t have visibility on these loans. In that context, it only takes a small tremor to bring that realization to light – and the bottom falls out. The health of the capital value chain we sell into requires a strong securities market with real visibility, understanding, and analysis of risk. When the market comes back from near extinction – as it will – that mistake will not happen again.
4. Manual Processing - Ten years ago, the market was even more fragmented than today, with thousands and thousands of small mortgage banks. Those banks built brute-force, manual processes to originate and sell a loan and push through a myriad of regulatory and investor requirements. They charged the borrower an origination fee and made profit by streamlining the operations through monolithic stovepipe operations. They moved the people who processed those operations to low-cost-of-living areas of the country. They tracked their processes with low-cost technology so they could measure and control productivity like a textile factory. As the market matured and consolidated, those manual processes survived and consolidated, too, even in sophisticated global financial services powerhouses that should know better. Manual processing must die out along with the stale technology that supports it. Mortgage processing just might be last bastion of pre-Demming manufacturing. (Demming was the American who transformed the low-quality Japanese automobile industry into a world-dominating manufacturing giant.) It is error prone, expensive, and non-agile and I eagerly look forward to its departure from the face of the earth.

Some extinction is good. No one will shed a tear when man discovers and implements a way to eradicate the AIDS virus. Like the super-croc, life is sometimes better with some healthy extinction.