While stakeholders have been busy
trying to carve out exceptions that fit their own agendas, it appears that Congress
may have been smart to put the "skin in the game" requirements in the
Dodd-Frank Financial Reform Act. At
least that's the conclusion of an Economic Letter published Monday under the
auspices of the Federal Reserve of San Francisco.
excluded some lending - mortgages insured, guaranteed, or purchased by a Farm
Credit System Institution or by an agency of the U.S. government - from its requirement
that a mortgage originator retain at least five percent of a loan that is pooled
into a mortgage-backed security (MBS). The legislation does not provide clear guidance on loans
originated under Freddie Mac and Fannie Mae guidelines. READ MORE
The Economic Letter, Mortgage-Backed Securities: How Important Is "Skin in the Game"? was written
by Christopher M. James, professor of finance at the Warrington College of
Business, University of Florida, and a visiting scholar at the Federal Reserve
Bank of San Francisco. He contrasts traditional lending, in which vertically
integrated lenders own and service the loans they originate under the "originate-to-distribute"
model in which securitization involves several different agents performing several different
services, often for fees that are unrelated to the performance of the
securitized loans. When entities do not
bear the full consequences of or responsibility for their actions "moral
hazard" arises. Critics, he said, contend that the ongoing credit crisis
is a direct result of a decline in lending standards fostered by moral hazard
in the originate-to-distribute securitization model.
To determine whether the
risk retention requirements are on target, James reviewed recent studies on how
the severity of moral hazard problems in the securitization process is related
to the structure and performance of securitized pools of residential MBS. James
uses the review to answer three related questions:
Does the performance of securitized mortgage loans vary depending on
how much skin securitizers have in the game?
Is retention of 5% credit risk enough to affect incentives?
Does MBS pricing reflect whether the originator has skin in the game?
In a paper published in Quarterly Journal of Economics, Atif Mian and Amir Sufi found that the ease of
securitizing subprime mortgages resulted in a big expansion of mortgage credit
to zip codes with a higher percentage of households with poor credit scores but
no corresponding evidence of increased income. The authors also found that
those zip codes that experienced the biggest increase in mortgage
securitization between 2002 and 2005 also experienced the biggest increase in mortgage default rates from
2005 to 2007, suggesting lax lending standards for securitized mortgages fueled the crisis.
Another Quarterly Journal paper published by Benjamin
J. Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant Vig, found that mortgages with
borrowers FICO scores just above a 620 threshold are much more likely to be
securitized than mortgages just below 620, but default rates are higher for
securitized mortgages with FICO scores just above 620 than for those just below
that score. This suggests originators
are less diligent screening loans they expect to securitize.
James said that evidence of
higher default rates among securitized loans is not in itself an indication
that the originate-to-distribute model is flawed. For example, MBS investors
may have broader diversification opportunities and are thus better positioned
to manage credit risk than originators. Critics contend that securitization
promoted lax lending because investors either misunderstood or ignored how
securitization affected originator incentives and consequently the riskiness of
the underlying mortgages. If MBS prices, however, include moral hazard
discounts, then sponsors and originators have an incentive to retain skin in
the game as a way of demonstrating higher underwriting standards that earn higher
values for securitized mortgages.
In order to gauge the
importance of "skin in the game," James looks at loss exposure which
he says differs depending on the relationship between originator, pool sponsor,
and pool servicer. Even when a loan is
sold without recourse, the originator may retain some loss exposure if there is
a breach of sale representations and warranties. The sponsor sets underwriting
guidelines for mortgages in the pool based on such parameters as FICO scores,
required documentation, loan-to-value ratios, amortization schedules, and
whether mortgage interest rates are adjustable or fixed and may retain the most
junior or residual securitization tranche. This implies that the sponsor has
first loss exposure as well as greater upside potential if the pooled mortgages
perform better than expected.
In terms of relationships,
there are three basic types of deals: affiliated deals where an originator
also serves as MBS sponsor and servicer; mixed deals where the sponsor is affiliated with one of several originators
and unaffiliated deals when the sponsor is
not an originator.
When a sponsor is affiliated
with a single originator, the originator retains both greater loss exposure and
greater upside profit potential than in unaffiliated deals. Also, an originator
that will retain servicing rights could have greater incentive to screen
borrowers carefully to maintain the value of those rights. When there is more
than one originator, there is an incentive to free ride on screening carried
out by other lenders. As a result, originator-servicer affiliation and
originator dispersion can distance originators from loss, i.e. reduce their
skin in the game. Moral hazard problems are expected to be greater when distance from loss is greater.
The third study, a working
paper by James and Cem Demiroglu examines the relationship between performance,
pricing, and distance from loss for a sample of Alt-A MBS. Performance was measured by calculating the
cumulative net loss rate in the sample's principal due to default.
If skin in the game
matters, one would expect loss rates to be lower for affiliated deals and
higher for mixed or unaffiliated deals and this was the case. Affiliated deals had
net loss of 2.1 percent compared to 4.3 percent for mixed and 44.4 percent for unaffiliated
deals. These differences were apparent even before the housing market started
to collapse. For example, by mid-2006, the loss rate on affiliated deals was
0.28%, roughly one-third the 0.76% loss rate on unaffiliated deals.
So, skin in the game
matters when it comes to performance. As
the residual interest retained by the sponsor in this study was 3% or less of the
total value of the securitization; these findings suggest that the 5% loss
exposure required by Dodd-Frank is likely to have a significant impact on loss
Finally, did investors
anticipate performance differences and therefore demand higher yields or credit
enhancement for MBS in when originators had less skin in the game? The Demiroglu
and James study compared the average yield and percentage of securities issued
with AAA ratings for affiliated and unaffiliated deals. Controlling for
mortgage and borrower risk characteristics, they found average yields significantly
lower on securities in affiliated deals relative to securities in unaffiliated
deals and affiliated deals were able to issue a relatively greater proportion
of securities with AAA ratings. These results suggest that investors considered
moral hazard when pricing MBS.