Mortgage-Backed Securities: How Important Is “Skin in the Game”?

Via FRBSF Economic Letter.

Many analysts believe that, during the housing boom of the 2000s, the widespread securitization of residential mortgages fundamentally altered the incentives of key players in the loan origination and funding process. A basic problem with the originate-to-distribute model of lending is that mortgage originators and the sponsors of mortgage-backed securities (MBS) have too little “skin in the game,” these critics argue. In contrast to traditional lending, in which vertically integrated lenders own and service the loans they originate, securitization involves different agents performing different services, often for fees that are unrelated to the performance of the securitized mortgage loans. A resulting danger is that originators and sponsors pay too little attention to the riskiness of the mortgages they originate or place into pools they sponsor.

Economists use the term “moral hazard” to refer to the change in incentives that arises when individuals or institutions do not bear the full consequences of or responsibility for their actions. Critics contend that the credit crisis that began in 2007 was a direct result of a decline in lending standards fostered by moral hazard inherent in the originate-to-distribute securitization model. In response to these concerns, Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the financial reform legislation recently passed by Congress, requires securitizers to retain at least 5% of the credit risk associated with the mortgages underlying residential MBS. In addition, the legislation prohibits securitizers from hedging or transferring that credit risk.

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