Securitization "Skin in the Game" Requirement in Reform Legislation May Be Problematic

A bedrock principle of legislative efforts to reform the securitization markets is that loan originators should be required to retain a percentage of the packaged asset-back securities. Passed late last year, the Wall Street Reform and Consumer Protection Act, HR 4173, would require companies that sell products like mortgage-backed securities to keep some “skin in the game” by retaining at least five percent of the credit risk. The Senate draft legislation also contains a similar retention requirement.

But in recent remarks at the American Securitization Forum, Comptroller of the Currency John Dugan questioned the efficacy of the ``skin in the game’’ retention requirement. Because of new accounting standards and capital rules, a requirement intended to revive the securitization market by improving the quality and trustworthiness of underwriting could have the perverse unintended consequence of significantly curtailing the number of securitizations that are actually done. For example, new FASB Standards166 and 167 eliminate qualified special purpose entities, which are the primary securitization accounting vehicle for asset-backed securities.

The reasoning behind requiring skin in the game is that securitizers retaining a material risk of loss on securitized loan have a strong incentive to ensure that the loans are soundly underwritten at origination, therefore better aligning the securitizer’s risk with that of the investors purchasing the securitized assets. While lauding this goal, the Comptroller said that mandatory risk retention for securitizers is an imprecise and indirect way to achieve the goal and is by no means guaranteed to work. Even more, there are significant accounting and regulatory capital issues arising from the recently issued standards and rules affecting the off-balance sheet treatment of securitized assets.

For one thing, the accounting issue arising from FAS 166 and 167, which took effect on January 1, is problematic. These new standards eliminated the use of qualifying special purpose entities to achieve true sales of assets to move them off a securitizer’s balance sheet. As a result, many previously securitized assets moved from off-balance sheet to on-balance sheet as of the beginning of this year.

The new standards make it considerably more difficult to structure securitization transactions to qualify as true sales to move assets off the balance sheet. Although the control test used in the new standards is not exactly the same as a risk transfer test, noted Mr. Dugan, the results are conceptually similar. The assumption is that the more control the securitizer retains over assets after securitization the greater the likelihood of ongoing exposure to risk of loss in the securitized assets, and the less likely it is that the risk of loss has adequately shifted to purchasers. As a result, the new accounting standards effectively require the books of securitizers to capture more ongoing risk from securitizations than the old standards.

The related bank regulatory capital issue arises from the changes to the accounting standards. Under recently finalized revisions to capital regulations, the banking agencies will continue to track GAAP, and the recent changes to GAAP, in determining sales treatment for regulatory capital purposes. As a result, the previously securitized assets that return to bank balance sheets for accounting purposes will require risk-based and leverage capital for regulatory. purposes, and so will assets securitized in the future that fail to meet the new standard for leaving the balance sheet.

The new accounting standards and capital changes create a lurking problem with the legislation’s skin-in-the-game requirements. When a securitizer retains a material risk of loss on loans transferred in a securitization, said the Comptroller, the accounting standards and capital rules may require that all loans in the securitization vehicle be kept on the bank’s balance sheet, not just the amount of risk required to be retained. In his view, this could significantly increase the regulatory capital charge for such securitizations. There are no bright lines, he noted, and whether securitized assets will be treated as staying on the balance sheet will be a facts and circumstances judgment based on a qualitative assessment of control.

While supporting the legislation’s ``skin in the game’’ provisions, the IMF cautioned that the retention requirement should not be imposed uniformly across the board, but tailored to the type of securitization and underlying assets to ensure that those forms of securitization that already benefit from skin in the game and operate well are not weakened.

The IMF also warned that policies designed to put more securitizer "skin in the game" also risk closing down parts of securitization markets if poorly designed and implemented. Variations in schemes that force securitizers to retain some slices of their securitized products can have dramatic effects on the incentives to improve loan screening, noted the IMF, in some cases with the unintended effect of making some types of securitization too costly to execute, effectively shutting down these markets.

Echoing OCC chief Dugan, the IMF also advised that the interaction of these schemes with changes to accounting standards and regulatory capital requirements should be carefully considered. Before implementing such schemes, authorities should conduct impact studies to ensure that they fully understand the potential effects of all the regulations in their totality.

The House legislation would require the Federal Reserve Board, in consultation with the SEC, to conduct a study and report to Congress on the impact on individual classes of asset-backed securities of FASB standards, FAS 166 and 167, and the Act’s new credit risk retention requirements. The report must make statutory and regulatory recommendations for eliminating any negative impacts on the continued viability of the asset-backed securitization markets and on the availability of credit for new lending.

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