Last year I was speaking with the chief financial officer of a subprime mortgage banking company that wasn't doing as well as it could. The company originated loans through retail and wholesale channels.

I asked what the returns were in each division, and I was given some very crude numbers that showed the profitability by division.

The first flaw was that the company assumed all loans to have the same value. If it received a weighted average price of 106 on its loan sales, it assumed that all loans were worth 106. But some loans were worth more than others, and the 106 was merely a weighted average.

The first necessary step is to analyze the profitability per loan based on loan level attributes. What if retail originates loans at a fully loaded cost of 97 and wholesale originates them at 102? It would appear that retail is five points more profitable, but is it?

What if retail has a weighted average coupon that is 150 basis points lower than wholesale? What if retail has an average prepayment penalty of 1.5 years and wholesale has prepayment penalties averaging 3.5 years? Somehow, each company must devise ways to factor in such differences.

It is not always so easy. Let's look at the higher coupon that wholesale has. It is absolutely critical that we look at the reason behind it.

If wholesale originates lots of C and D loans and retail originates lots of A-minus loans, wholesale will have higher-rate-but much riskier - loans. Senior management will have to decide how to weight this.

Management then must look at returns on invested capital. Let's use a very simple example: Retail generates a profit of \$400 per loan and wholesale generates a profit of \$200 per loan. Let's assume that this includes all expenses and that it adjusts for all attributes such as coupon, prepayment penalties, and so on.

The unsophisticated manager will see that retail is twice as profitable as wholesale: \$400 per loan versus \$200 per loan. The more sophisticated manager will want to know how much capital is used by each division and what its cost is.

Let's now assume that the cost of capital is 15%, and that retail requires \$4,000 of capital to produce a loan, while wholesale requires \$1,000.

In this example, an unsophisticated management would notice that retail makes \$400 per loan versus only \$200 per loan in wholesale. If the cost of capital is not factored in, management would believe that retail should be given more resources than wholesale. Their advantage budget would be increased, and they might be encouraged to open new branches.

However, retail uses up \$4,000 of capital to produce a profit of \$400 per loan, while wholesale uses only \$1,000 to produce \$200. Retail's profit of \$400 is not even enough to cover its \$600 cost of capital. In fact, the more retail loans the company does, the more it will deplete its capital.

Our first glance tells us that retail has a higher profit margin -and it does. But factoring in the cost of capital tells us that it is actually a destroyer of value. Thus, a rational management would want to allocate more resources to wholesale in spite of its lower profit margin.

I am not taking the wholesale side over retail. My point is simply that profitability analysis is not as simple as an income statement. It must factor in the attributes of the loans a division originates, and it must look at the capital each division requires.

Only then can management make the proper decisions about where to allocate resources.