When Good Incentives Go Bad

A few days ago, I was in New York talking with some senior executives at one of the country’s largest financial-services firms. Ironically enough – in the land of $800/night closet-sized hotel rooms and $40 scrambled-egg breakfasts – we were discussing the capital crunch and, more specifically, its impact on the future of mortgage origination.

One of the executives asserted we will soon see significant legislation to regulate mortgage brokers. I agree. And, like him, I don't think increased regulation will necessarily be bad for the brokers or our industry in general. In fact, a stricter, appropriate regulatory framework that permanently changes the way originators conduct their business is probably long overdue.

That point was hammered home to me several days later when I downloaded testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs on the Subprime Mortgage Market Turmoil: Examining the Role of Securitization. What has become painfully clear is that incentives have slowly but surely become wildly misaligned with solid, conservative business and lending practices.

One reason for this misalignment is fundamental. For a large majority of broker-originated loans (which in 2006 ballooned to well more than 60 percent of all volume), the customer-facing broker – who initiates and manages the relationship with the borrower – is not the entity that actually funds the loan. According to the testimony I read, this has the "the absurd result… that the federal statute which purports to promote useful and accurate disclosure of credit prices, does not govern the business or individual that actually speaks to a mortgage applicant." Stated differently: today’s regulations are aimed at the lender not the broker.

Another fundamental reason – one that has played a large role in the subprime meltdown – is that the incentives that drive the loan broker and originator are fundamentally inefficient. An insurance broker, for instance, gets paid on the annuity. But a mortgage broker is not paid out of monthly payments borrowers make on their loans. Instead, he’s paid on the booked value of the loan at closing. His income comes from the closing costs and proceeds of selling the loan to secondary investors. With more (and bigger) loans, the broker makes more money. The incentives are short term and according to the testimony motivate "to cut corners in the underwriting process... and [encourage buyers to] borrow more money than they can afford. It also puts pressure on appraisers to appraise home values higher in order to facilitate these loans."

Are Software Vendors' Incentives Aligned with Yours?

In the software industry, this discussion of incentives presents some very strong and, frankly uncomfortable, parallels. Traditionally, software makers deliver their products through perpetual software licenses, professional services, and a modest annual maintenance fee. The sales motivation is to increase the upfront size of the contract and get it out the door as fast as possible. That’s because, as soon as the product ships, the software company receives cash and recognizes the revenue and the sales rep receives his compensation. It all happens before the customer receives any value.

Unfortunately, this is happening all too often. In MIT's Sloan Management Review, Cynthia Rettig points out that 75 percent of all ERP systems – implementations that cost an average of $15 million (or hundreds of millions of dollars for large companies) – were considered failures. This is presumably due to both the inflated monolithic complexity of the systems themselves and the inherent industry incentives: get the big contract up front.

This is why I love the SaaS model so much. It removes the incentive to inflate upfront costs or contract sizes. With SaaS, incentives are solely derived from the monthly annuity stream paid by the customer after they go live – not before.

In most SaaS models, the software is already deployed. There is no risk of failure. Even with mission-critical, highly negotiated enterprise Software as a "Customized" Service (SaCS), the incentive is the same: long-term success measured and billed on a monthly basis. And – it bears repeating – payment aren’t received until the customer goes into production. The only incentive is to start and maintain the monthly recurring subscription.

It might seem like fundamentally good business – but unfortunately, our industry is due to receive a very painful reminder: long-term market success is achievable only when incentives are properly and efficiently aligned.

I’d love to hear your thoughts and experiences in this area.

Dain Ehring
CEO Dorado Corporation
dehring@dorado.com
650-227-7330