The Treasury Department yesterday released a report on “risk retention”. It noted that because loan originators had no “skin in the game”, securitization helped fuel the housing bubble. To fight this they said:
- [A]s the recent financial crisis demonstrated, without reform, risks in the securitization process can detract from these benefits. Leading up to the recent crisis, originators and securitizers made loans, bundled them together, and then sold them off to a broad array of outside investors, often without retaining a meaningful share of the risk. Because originators had little interest in whether the borrowers would be able to repay the loans, underwriting standards deteriorated and excessively risky mortgages flooded the market. This helped fuel the financial crisis.
- To address this serious flaw in the pre-crisis securitization market, the Dodd-Frank Act generally requires that securitizers or originators have “skin in the game” by retaining at least 5 percent of the credit risk of an asset sold to investors through the securitization process, which should allow market participants to price credit risk more accurately and allocate capital more efficiently.
- By putting in place such safeguards, the Dodd-Frank Act can help ensure that securitization is a stable and reliable source of credit for consumers, businesses, and homeowners in the United States.
“Skin in the game” is a useful concept. It seems unlikely to be helpful however when the game is played using someone else’s skin. Note this statement found on page 23:
A risk retention framework could consider allowing a third party guarantor to satisfy risk retention requirements by taking part or all of the credit risk. The residential mortgage securitization market evolved to allow a number of third parties to provide external credit support, either to the underlying loans or the securities. Of particular note are Fannie Mae, Freddie Mac, the Federal Housing Administration (and other government agencies), private mortgage insurance (“PMI”) providers, and bond insurers.