Does Having "Skin in the Game" Matter in the Mortgage Business?

While stakeholders have been busyrntrying to carve out exceptions that fit their own agendas, it appears that Congressrnmay have been smart to put the “skin in the game” requirements in thernDodd-Frank Financial Reform Act.  Atrnleast that’s the conclusion of an Economic Letter published Monday under thernauspices of the Federal Reserve of San Francisco.</p

Dodd-Frank specificallyrnexcluded some lending – mortgages insured, guaranteed, or purchased by a FarmrnCredit System Institution or by an agency of the U.S. government – from its requirementrnthat a mortgage originator retain at least five percent of a loan that is pooledrninto a mortgage-backed security (MBS). The legislation does not provide clear guidance on loansrnoriginated under Freddie Mac and Fannie Mae guidelines. READ MORE </p

The Economic Letter, Mortgage-Backed Securities: How Important Is “Skin in the Game”? was writtenrnby  Christopher M. James, professor of finance at the Warrington College ofrnBusiness, University of Florida, and a visiting scholar at the Federal ReservernBank of San Francisco. He contrasts traditional lending, in which verticallyrnintegrated lenders own and service the loans they originate under the “originate-to-distribute”rnmodel in which securitization involves several different agents performing several differentrnservices, often for fees that are unrelated to the performance of thernsecuritized loans.  When entities do notrnbear the full consequences of or responsibility for their actions “moralrnhazard” arises. Critics, he said, contend that the ongoing credit crisisrnis a direct result of a decline in lending standards fostered by moral hazardrnin the originate-to-distribute securitization model.</p

To determine whether thernrisk retention requirements are on target, James reviewed recent studies on howrnthe severity of moral hazard problems in the securitization process is relatedrnto the structure and performance of securitized pools of residential MBS. Jamesrnuses the review to answer three related questions: </p<ul class="unIndentedList"<liDoes the performance of securitized mortgage loans vary depending onrnhow much skin securitizers have in the game? </li<liIs retention of 5% credit risk enough to affect incentives?</li<liDoes MBS pricing reflect whether the originator has skin in the game? </li</ul

In a paper published in Quarterly Journal of Economics, Atif Mian and Amir Sufi found that the ease ofrnsecuritizing subprime mortgages resulted in a big expansion of mortgage creditrnto zip codes with a higher percentage of households with poor credit scores butrnno corresponding evidence of increased income. The authors also found thatrnthose zip codes that experienced the biggest increase in mortgagernsecuritization between 2002 and 2005 also experienced the biggest increase in mortgage default rates fromrn2005 to 2007, suggesting lax lending standards for securitized mortgages fueled the crisis.  </p

Another Quarterly Journal paper published by BenjaminrnJ. Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant Vig, found that mortgages withrnborrowers FICO scores just above a 620 threshold are much more likely to bernsecuritized than mortgages just below 620, but default rates are higher forrnsecuritized mortgages with FICO scores just above 620 than for those just belowrnthat score.  This suggests originatorsrnare less diligent screening loans they expect to securitize. </p

James said that evidence ofrnhigher default rates among securitized loans is not in itself an indicationrnthat the originate-to-distribute model is flawed. For example, MBS investorsrnmay have broader diversification opportunities and are thus better positionedrnto manage credit risk than originators. Critics contend that securitizationrnpromoted lax lending because investors either misunderstood or ignored howrnsecuritization affected originator incentives and consequently the riskiness ofrnthe underlying mortgages. If MBS prices, however, include moral hazardrndiscounts, then sponsors and originators have an incentive to retain skin inrnthe game as a way of demonstrating higher underwriting standards that earn higherrnvalues for securitized mortgages. </p

In order to gauge thernimportance of “skin in the game,” James looks at loss exposure whichrnhe says differs depending on the relationship between originator, pool sponsor,rnand pool servicer. Even when a loan isrnsold without recourse, the originator may retain some loss exposure if there isrna breach of sale representations and warranties. The sponsor sets underwritingrnguidelines for mortgages in the pool based on such parameters as FICO scores,rnrequired documentation, loan-to-value ratios, amortization schedules, andrnwhether mortgage interest rates are adjustable or fixed and may retain the mostrnjunior or residual securitization tranche. This implies that the sponsor hasrnfirst loss exposure as well as greater upside potential if the pooled mortgagesrnperform better than expected. </p

In terms of relationships,rnthere are three basic types of deals: affiliated deals where an originatorrnalso serves as MBS sponsor and servicer; mixed deals where the sponsor is affiliated with one of several originatorsrnand unaffiliated deals when the sponsor isrnnot an originator. </p

When a sponsor is affiliatedrnwith a single originator, the originator retains both greater loss exposure andrngreater upside profit potential than in unaffiliated deals. Also, an originatorrnthat will retain servicing rights could have greater incentive to screenrnborrowers carefully to maintain the value of those rights. When there is morernthan one originator, there is an incentive to free ride on screening carriedrnout by other lenders. As a result, originator-servicer affiliation andrnoriginator dispersion can distance originators from loss, i.e. reduce theirrnskin in the game. Moral hazard problems are expected to be greater when distance from loss is greater.</p

The third study, a workingrnpaper by James and Cem Demiroglu examines the relationship between performance,rnpricing, and distance from loss for a sample of Alt-A MBS.  Performance was measured by calculating therncumulative net loss rate in the sample’s principal due to default.</p

If skin in the gamernmatters, one would expect loss rates to be lower for affiliated deals andrnhigher for mixed or unaffiliated deals and this was the case. Affiliated deals hadrnnet loss of 2.1 percent compared to 4.3 percent for mixed and 44.4 percent for unaffiliatedrndeals. These differences were apparent even before the housing market startedrnto collapse. For example, by mid-2006, the loss rate on affiliated deals wasrn0.28%, roughly one-third the 0.76% loss rate on unaffiliated deals. </p

So, skin in the gamernmatters when it comes to performance.  Asrnthe residual interest retained by the sponsor in this study was 3% or less of therntotal value of the securitization; these findings suggest that the 5% lossrnexposure required by Dodd-Frank is likely to have a significant impact on lossrnrates.</p

Finally, did investorsrnanticipate performance differences and therefore demand higher yields or creditrnenhancement for MBS in when originators had less skin in the game? The Demiroglurnand James study compared the average yield and percentage of securities issuedrnwith AAA ratings for affiliated and unaffiliated deals. Controlling forrnmortgage and borrower risk characteristics, they found average yields significantlyrnlower on securities in affiliated deals relative to securities in unaffiliatedrndeals and affiliated deals were able to issue a relatively greater proportionrnof securities with AAA ratings. These results suggest that investors consideredrnmoral hazard when pricing MBS.

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