Outsourcing deserves some blame for financial crisis

By: Dan Cunningham

Posted: 10/6/08

When most people hear about "outsourcing," they often think of corporations moving manufacturing jobs to developing countries like India or China, or American blue-collar families losing their homes and dignities. We might see sweatshops or greedy CEOs lining their wallets at the cost of the American Dream for the common person. Politics has made this word almost dirty in character, which clouds our analysis of it. However, addressing this very process could be part of the solution for turning around the financial crisis we are experiencing today.

Outsourcing, at its most basic, is the process of moving a function out of one organization and into another. When a manufacturer supplies a local retailer with their product, they have outsourced the function of selling. The theory behind this is that a company can remove 'sources' of costs and responsibility to a firm who has the resources to address it better. It allows for specialization and simplifies the responsibilities for the company.

As we study the economy today, one must recognize the purpose this basic concept of outsourcing has served in our ongoing financial meltdown. The financial industry is a dense one and outsourcing often occurs in the face of such complexity. Consider the process of receiving a loan. Lenders must perform rigorous background research on a prospective borrower. They must validate factors like property value, borrower income and credit history. They must write up contract terms, then secure and transfer the funds. These are all time consuming and costly procedures, leaving lots of room for error.

When the financial industry was developing, a separation of functions emerged. Businesses were created with the sole function of contract writing and selling and others for background checks and credit history. In addition, there are the banks that pay for it. For simplicity, we can call them the salespersons, the banks and the detectives. Right here, a conflict of interest emerges between the groups.

A salesperson has one job: Get the loan. The firms invested in selling loans are not directly paying for it. After they acquire the loan, they outsource it to a bank. A bank will pay them a lump sum for the loan, and the salesperson continues business. The bank buys loans in large, billion dollar packages. These packages had an estimated yield, which the salesperson was responsible for calculating. The packages hold so many loans that it was perceived to be too costly for the bank to accurately verify that they would actually be paid off. The detectives were only responsible for credit history, so their analysis was irrelevant in determining if the borrowers would pay off the future interest rates. This leads to an inevitable cost of outsourcing.

Outsourcing any function means you sacrifice the information that comes with that process. Salespeople were not held responsible, and therefore did not research the future ability of a borrower to pay the loan. Worse, they were incentivized to withhold any information from banks that would alert them that the borrowers might foreclose. This lack of transparency has corrupted the system and had perverse effects on almost every financial-related industry in the country.

The conflict of interests that caused this to happen was never corrected. The industry, after feeling the crash, has nearly stopped lending for fear of imperfect information. The $700 billion question arises, where do we go now? Congress is trying to take on the burdens of the industry in order to maintain business as usual. They have proposed several measures intended to reduce the fear of failure to lenders. This should raise concerns from us both as voters and prospective future homeowners. We should all be asking: Is Congress addressing the causes of the failure? Are their bills, which are intended to free up credit, improving or harming the economy? Is their stimulus plan counterproductive to establishing a stable financial environment?

We might not have definitive answers to those questions for years, so it is critical to ensure that they make the right decision the first time, before it comes back to bite us.