Proposed Risk Retention Rule Simply Misses the Point

Yesterday, the six major U.S. financial services regulatory agencies announced their joint-proposal for the guidelines that issuers of securitized debt instruments will be expected to follow, as a result of the “risk retention” standards set by the Dodd-Frank legislation.

We suppose it’s really not their fault.  After all, the law is the law.  Nevertheless, something just doesn’t sit right with us as we continue to ask, where are the industry experts when you need them?  The proposal is a slightly modified version of what has been kicked around since 2008 and crowed about from the rooftops by every politician and pundit on the planet…….. the answer to this whole mess is “skin-in-the-game” or shall we say “skininthegame”, since the phrase has been so over-used for so long that it has become one word?

As far as we can tell, this entire discussion has been hijacked by the same type of “faulty assumption theory” that brought the securitization industry to its knees to begin with; namely the over reliance on someone else in the process, based on the assumption that “they are the experts and they should know what they are doing”.

In the case of the securitization industry of the mid-2000’s, otherwise sophisticated investors relied too much on the rating agencies, who relied too much on the underwriters, who relied too much on their models and third-party experts, who relied too much on the originator’s underwriting methods, who relied too much on their “relationship” with their mortgage bankers, etc, etc, etc.

Is it us, or did we read too much latitude into Dodd-Frank, as the legislative end of this whole business (never one to take a position that they couldn’t back off from gracefully) seemed to be giving the regulatory bodies a wide berth to implement the intent of the legislation as those bodies see the legislation best fits their markets?  After all, the regulators are the experts!

On the other hand, maybe we expected too much of the regulators, as the shortage of “political cover” for their own political or private sector aspirations may not have given the leadership of these agencies much choice but to go with the flow of “current conventional wisdom”.

The problem we see is that the basis for all this policy seems to be well rooted in any number of false conclusions and assumptions.

In no particular order, here are some the things that are nagging us…….

1) 5% Retention Level:  We find no real logic behind this level.  As with many rules and regulations devised under duress, this seems to largely an arbitrary figure.  We can’t help but come back to a scenario where an unrepentant issuer, with horribly deficient underwriting standards taps the market for a $500mm securitization of sub-prime mortgages.  Does anyone really think that this issuer is going to think twice about the fact that they must retain $25mm of the pool, when they can unload the other $475mm?

We know, you’re going to say “but wait a minute!  There are other ways to prevent this from happening.” and we would be the first to agree with you.  Stopping the cheat should not be a matter an exercise of trying to put the genie back in the bottle or one which penalizes the frequent or large issuer and that is what we believe the 5% rule does.

2) The Fox and the Fox:  From our little corner of the room, we can’t help but continue to feel that much of this whole process has been one big chess game with both the legislative and the regulatory bodies trying to stay focused on one very mutually beneficial objective; namely to make sure that no one remembers that it was the Government doing all the encouraging to open up the mortgage markets and then turning their back to the abuses in the origination process.  It has always been easier to blame the inmates for conditions in the asylum.  One section of the SEC’s published notice is telling……..

“When properly structured, securitization provides economic benefits that lower the cost of credit to households and businesses.  However, when incentives are not properly aligned and there is a lack of discipline in the origination process, securitization can result in harm to investors, consumers, financial institutions, and the financial system.

 During the financial crisis, securitization displayed significant vulnerabilities to informational and incentive problems among various parties involved in the process.

For example, as noted in the legislative history of section 15G, under the “originate to distribute” model, loans were made expressly to be sold into securitization pools, with lenders often not expecting to bear the credit risk of borrower default.  In addition, participants in the securitization chain may be able to affect the value of the ABS in opaque ways, both before and after the sale of the securities, particularly if those assets are resecuritized into complex instruments such as collateralized debt obligations (CDOs) and CDOs-squared.  Moreover, some lenders using an “originate-to-distribute” business model loosened their underwriting standards knowing that the loans could be sold through a securitization and retained little or no continuing exposure to the quality of those assets.

 The risk retention requirements added by section 15G are intended to help address problems in the securitization markets by requiring that securitizers, as a general matter, retain an economic interest in the credit risk of the assets they securitize. As indicated in the legislative history of section 15G, “When securitizers retain a material amount of risk, they have ‘skin in the game,’ aligning their economic interest with those of investors in asset-backed securities.”

By requiring that the securitizer retain a portion of the credit risk of the assets being securitized, section 15G provides securitizers an incentive to monitor and ensure the quality of the assets underlying a securitization transaction, and thereby helps align the interests of the securitizer with the interests of investors. Additionally, in circumstances where the assets collateralizing the ABS meet underwriting and other standards that should ensure the assets pose low credit risk, the statute provides or permits an exemption.

 The credit risk retention requirements of section 15G are an important part of the legislative and regulatory efforts to address weaknesses and failures in the securitization process and the securitization markets. Section 15G complements other parts of the Dodd-Frank Act intended to improve the securitization markets. These include, among others, provisions that strengthen the regulation and supervision of nationally recognized statistical rating agencies (NRSROs) and improve the transparency of credit ratings; provide for issuers of registered ABS offerings to perform a review of the assets underlying the ABS and disclose the nature of the review; and require issuers of ABS to disclose the history of the repurchase requests they received and repurchases they made related to their outstanding ABS.”

We could go on at some length about several “freudian moments” in this passage but the central point is that this proposal and all the arguments that go with it are essentially an attempt to fix problem in the “asset origination” process by restricting the “securitization origination process”.  How about focusing the cure on the source of the problem?  Of course if they did that, it would shed light on just how lax and just how negligent the cops on the beat were throughout the past decade. 

3)  To Praise or to Defile Securitization:  “To be or not to be!  That is the question for securitization.”  On the one hand, regulators have continuously sung the praises of securitization’s significant role in a robust capital market.  Once again, even the above passage describes how securitization represents one of the most efficient methods for ensuring that consumer borrowing costs are affordable.  Why then would the centerpiece of the regulators proposals attempt to artificially increase those costs by a) forcing so many borrowers away from the “Qualifying Residential Mortgage” market and b) imposing an extra cost to the securitization program in the form of the 5% retention rule.  If something is that important to a well operating market, then why would you try to stymie it; particularly when it is not the securitization process itself which is the real problem?

We would probably agree with the many that are now projecting both 1) a more costly consumer market in those markets that have traditionally relied on securitization to fund their operations and 2) a vastly smaller market where it may prove difficult for many borrowers to even find a lender in critical consumer markets such as residential mortgages, autos and credit cards.

Somehow the regulators, the “experts”, seem to have missed the point.

About markferraris
Managing Principal Orchard Street Partners LLC

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