Federal regulators have finalized a new risk-retention rule, a process mandated by the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act. Title IX of Dodd–Frank requires all mortgage securitizers—any firm that packages and sells mortgages into mortgage-backed securities (MBS)—to retain a 5 percent credit risk in the underlying mortgages.
The logic behind the rule is that it will protect investors because it forces companies to keep “skin in the game” when they sell mortgages. Put differently, the rule provides securitizers with an incentive to package only high-quality mortgages into MBS because they can lose money on the underlying mortgages. This type of loss was not possible under the old framework. But one of the main reasons private markets evolved this way was due to the operations of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.
Critics argue that the GSEs merely followed the private market’s lead in taking on risky mortgages, but it’s clear that private-label securitization increased in lockstep with GSE purchases of private-label MBS. From 2003 to 2004, for example, the GSEs purchased approximately 40 percent of all the new MBS issued by private firms.
There was little need for private firms to develop stricter standards because they had two guaranteed buyers, the GSEs. Had we allowed private markets to accept their own financial risks, then they most likely would have adequately accounted for that risk.
That’s not to say private investors never make mistakes, but carelessly taking on too much risk is not the way most successful investors operate. On the other hand, when investors know they have government protection against losses, they’re less likely to pay as much attention to risks.
So in a system with taxpayer-backed MBS, it does make sense to have a risk-retention rule. If structured properly, the rule could provide much needed taxpayer protection.
Former Representative Barney Frank (D–MA), a coauthor of Dodd–Frank, probably understood this relationship when he referred to the new risk-retention rule as “the single biggest thing in the law.”
To the extent that Frank was right, the second biggest item is the law’s exemption for the risk-retention rule. Dodd–Frank requires securitizers to retain a 5 percent credit risk in all the mortgages they sell, except for those loans that qualify for an exemption.
The new rule is nearly 600 pages, and there are many other details (and problems), but the only thing that really matters for now is this exemption. Specifically, any loans sold to Fannie Mae or Freddie Mac are exempt from the rule. This fact alone means that virtually all new mortgages in the U.S. are exempt from the risk-retention rule.
At best, this exemption highlights that federal officials are more concerned with mortgage volume rather than the mortgage market’s safety and soundness. At worse, the exemption is gross negligence. Either way, the rule can’t possibly help protect taxpayers because virtually all new mortgages are exempt from the rule.
Securities and Exchange Commissioner Daniel Gallagher, who dissented from the SEC’s decision to adopt the rule, rhetorically asked, “What is the point of promulgating a risk retention standard and then exempting everything from it?” That’s a great question.
An even better question is: What’s the best way to protect taxpayers from MBS losses?
The best way to protect taxpayers is to stop forcing them to bear these risks in the first place by shutting down the GSE system.
