Battle Over Skin-in-the-Game Rules Heats Up

There are a couple of good articles circulating this week detailing the punches being exchanged between various market participants and with regulators over setting some final rules around Risk Retention guidelines for residential mortgage lenders and servicers.

Broadly speaking, Dodd-Frank set forth a rule requiring issuers of securitized mortgage debt to retain 5% of the risk (loan) in connection with a securitized portfolio.  The legislation also provided Government regulators with the flexibility to define (or refine) the definition for what types of loans would be covered by this 5% rule. 

As you might expect, the ‘interpretive discretion’ afforded the FDIC and other regulators has spawned a tidal wave of lobbying by a number of financial institutions that will be affected (either positively or negatively) by these rules.

We have been saying for many months that, while this seemingly straightforward attempt to rein in unnecessary risk taking by mortgage lenders (i.e. quickly transferring mortgage risk to unsuspecting investors in mortgage-backed securities) seemed logical to many at the time, we believe that the only thing this requirement will do is raise the cost of a securitization. 

It is likely that this increased cost will manifest itself in a couple of  ways:

1- It will reduce the size of the securitization market as issuers absorb the increased “cost of funding” and look to other (suddenly more competitive) alternatives for capital formation.  Net-net, business models for lenders will suffer.

2- Some or most of these costs will be transferred to other parties, whether that be equity investors (reduced returns/dividends) or borrowers (higher interest rates).

Interestingly, several  market constituents are fully engaged in trying to influence the final regulations to benefit their own business models and, perhaps, give themselves a competitive advantage.  One example could be Wells Fargo, who is now on record recommending that only residential mortgages that involve a 30% down payment should be exempted from the 5% retention rule.  Since a large portion of Wells Fargo loans fit this criteria, that would seem to give them a competitive advantage in the securitization market going forward.

Of course, the notion of returning the US Mortgage Market to the ‘old days’ of high down payment mortgages does not sit so well with many consumer advocates, the mortgage insurance industry and lenders with businesses built around a low down payment model.

It would appear that the old adage of  “if you push on one side, something is bound to come out on the other” would seem to apply to this debate.  Maybe the seemingly straightforward concept of skin-in-the-game isn’t quite as simple as many first thought.

About markferraris
Managing Principal Orchard Street Partners LLC

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