The Impact of Risk Retention Regulation on the Underwriting of Securitized Mortgages
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The Impact of Risk Retention Regulation on the Underwriting of Securitized Mortgages Craig Furfine 1 Received: 6 December 2018 / Revised: 1 March 2019 / Accepted: 3 March 2019 # Springer Science+Business Media, LLC, part of Springer Nature 2019
Abstract The Dodd-Frank Act requires securitization sponsors to retain not less than a 5% share of the aggregate credit risk of the assets they securitize. This paper examines how the implementation of risk-retention requirements affected the market for securitized mortgage loans. Using a difference-in-difference empirical framework, I find that risk retention implementation is associated with mortgages being issued with markedly higher interest rates, yet notably lower loan-to-value ratios and higher income to debt-service ratios. In addition, after controlling for observable loan characteristics, loans subject to risk retention requirements appear to be less likely to become troubled. These findings suggest that the risk retention rules have made securitized loans safer in both observable and unobservable dimensions, yet are more expensive to borrowers. Further evidence suggests that the risk-retention rules are binding, with the amount of risk being retained following implementation roughly three times that of before, while lenders also seemed to accelerate the securitization of originated loans during the months immediately before the rules took effect. Keywords Dodd-Frank . Securitization . Risk retention . Mortgages . CMBS JEL Classification G14 . G21 . G23 There have been a number of reasons proposed as to why securitization markets fared so poorly during the financial crisis. Among the most common explanations are those related to incentive problems among the parties to the securitization process — the originators, the sponsors, and the investors. According to common perception, firms originating mortgages quickly sold them, relieving them of any downside risk if a mortgage borrower ultimately defaulted. Similarly, sponsors pooling mortgage loans quickly passed along the risk of default to the investors of mortgage-backed securities (MBS). This “originate to distribute” model is * Craig Furfine [email protected]
1
Department of Finance, Kellogg School of Management, 2211 Campus Drive, Evanston, IL 60208, USA
Journal of Financial Services Research
believed to have led to originators becoming lax in their screening of risks, thereby reducing the quality of assets being securitized. As expressed by the Financial Crisis Inquiry Commission (2011), “Collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis.” Thus, it is no surprise that after the fact, financial regulators and policymakers incorporated risk retention or “skin in the game” requirements as part of the reform of financial markets specified by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. This component of the law attempts to align the incentives of the various parties involved in securitizations
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