The San Francisco Fed has a new paper that tries to answer the question of whether mandatory risk retention for securitisers of RMBS is a good idea.
The short answer is ‘yes’. But for those among you who get excited by this kind of thing (we know you’re out there), here’s the longer answer…
To assess whether risk retention actually has an impact on the performance of RMBS (ie whether sponsors who retained the greatest risk had fewer losses), the author of the paper, Christopher James, looked at the cumulative losses on Alt-A MBS as of August 2009.
A few quick definitions are required before looking at the results. An affiliated deal is one where the sponsor also functions as the sole originator and servicer of the mortgages that are put into the RMBS pool. A mixed deal is one where the sponsor is only one of the originators, whereas in an unaffiliated deal the sponsor is not one of the originators.
As James notes, a sponsor will normally retain the most junior tranche in the pool, and will accept both the risk of loss and the upside that comes with it. When an originator is not also a sponsor, its risk is whether a later breach in representations and warranties is discovered.
A bit more explanation from the paper itself:
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 expects to retain servicing rights could have greater incentive to screen borrowers carefully, because the value of mortgage servicing rights increases when the expected duration of a mortgage is longer. Moreover, the incentive to free ride on screening carried out by other lenders is likely to be greater when the number of originators is larger. As a result, originator-servicer affiliation and originator dispersion can be used as measures of distance from loss, that is, the degree to which originators have reduced their skin in the game.
In other words, affiliated deals mean that the originator is also taking on the risks associated with sponsoring and servicing — it’s the same entity throughout the process. The idea is that originators will have less of an incentive to be lax in their screening of potential loans because they will bear some of the loss if those loans go sour.
James looked at this added risk retention, controlled for the type of deal. You would expect that affiliated deals would have lower average cumulative loss rates than mixed and unaffiliated deals, and that’s exactly what James found:
The notion that securitisers (the originators in the James paper) should retain 5 per cent risk for any asset that is “transferred, sold, or conveyed” through the securitisation chain was a part of Dodd-Frank — but the bill also left various federal agencies, including the SEC and FDIC, to work out the details. The SEC had already included risk retention in its proposed changes to Reg AB, and the FDIC later followed suit.
And as FT Alphaville’s Tracy Alloway reported in October, the Fed released a 96-page paper looking at the many complications involved in actually applying risk retention. To pick just one: Given the potential conflicts of interest among the different players along the securitisation chain that will inevitably arise, it’s unclear exactly what kind of risk retention should apply to each.
Arriving at a sensible way to apply it therefore won’t be easy, but it does seem as if the general idea has empirical support.