On March 31 the SEC began seeking public comment on its proposed “skin in the game” regulation, which would require lenders and bond issuers of asset-backed securities (ABS’s) to retain 5% of the credit risk of the securities they issue. This requirement would apply to each of the tiers of ABS’s issued individually, preventing a lender or bond issuer from issuing a large proportion of risky securities and yet only retaining its 5% stake in those safer, higher-grade securities it issues. In the alternative, a lender or bond issuer could also comply with the regulation by retaining 5% of the first-loss residual interest of all ABS’s issued or a 5% interest in a representative sample of the underlying securities.
The rule is one of the many proposed by the SEC in accordance with the mandates of the Dodd-Frank Act. The rule was motivated by the public perception that there was an incentive problem, often referred to as a moral hazard, inherent in lending practice that became hegemonic in the mortgaged-backed securities (MBS’s) market. The potential problem lies in the fact that the banks and lenders extending loans to home buyers may not fully appreciate the credit risk of doing so because of their ability to turn around and easily sell these mortgages on the secondary market (commonly referred to as the “originate-and-distribute” model). Large financial institutions, acting as intermediaries between these lenders and investors, would buy mortgages and combine many of them into an investment tool, dividing the pool of mortgages into traunches (with returns on investment commensurate with the perceived security of the traunch invested in). While this securitization process is effective at providing greater liquidity in the mortgage market (as more investors will be willing to invest in the industry if the risk of default can be managed and mitigated through diversification and stratification inherent in the securitization process) the process also debased the incentive for lenders and bond issuers to ensure that borrowers were truly credit-worthy and able to sustain their mortgage payments.
A major exception to SEC’s proposed regulation exists for qualified residential mortgages (QRM’s; for an in-depth discussion of QRM’s, see previous post: Bigger than Fannie and Freddie: Defining Qualified Residential Mortgages). The proposal currently defines QRM’s as those with front-end and back-end debt-to-income ratios of 28% and 36%, respectively. Additionally, a QRM can only have a loan to value (LTV) ratio of 80% (though the LTV for refinancing is lower), necessitating a 20% down payment for potential home buyers. These exceptions are intended to balance the need to protect liquidity in the mortgage market, which is tremendously important to ensuring that potential home buyers have access to necessary capital, and protecting home buyers (as well as investors) from risky lending practices. By exempting QRM’s from the risk retention regulation, the 5% that would otherwise have to be retained by lender/bond issuer can be lent out, increasing access to capital.
Some will argue that these exemptions are not broad enough to allow lenders and bond issuers to maintain the level of liquidity in the mortgage market necessary for the nation to maintain its commitment to widespread homeownership, particularly for mid- to low-income families. The system sets up incentives for lending under QRMs, but a potential homebuyer looking to purchase a $300,000 home would have to save up for a $60,000 down payment in order to even be eligible for a QRM (other qualifications include credit history, income, and other factors). Such an accumulation of capital may not be realistic for potential home buyers, particularly young, middle and lower-class individuals, which may end up depriving persons from these groups of the opportunity to become homeowners.
Those in favor of the proposal will respond by noting that the regulation may increase investor confidence in MBS’s once again, which will result in greater capital infusion in the mortgage market and subsequently increase home buyer’s access to capital. The argument can also be made that a 5% risk retention is not significant enough to affect liquidity in the mortgage market. Those opposed to the regulation will respond by arguing that, by extension, 5% would also be insufficient to change behavior of lenders and bond issuers, thus simply acting as a friction in the market or residential mortgages. A final version of the regulation will not be released until the comment period closes and the SEC has time to review the feedback it receives.