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.

Dodd-Frank specifically 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 rates.

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.