May 11, 2011

Transparency as an Alternative to the Federal Government's Regulation of Risk Retention

Testimony Before the House Committee on Oversight and Government Reform, Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs
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Chairman McHenry, Ranking Member Quigley, and distinguished members of the Subcommittee, thank you for inviting me to testify today. I have been asked to offer opinions on the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd- Frank”) and its impact on Securitization, particularly risk retention.

There were a host of contributing factors to the rise and subsequent collapse of housing prices that decimated households, financial institutions and investors (including pension funds). For example, it has been argued that the Federal Reserve’s expansionary monetary policy supplied the means for unsustainable housing prices and unsustainable mortgage financing.1 In Figure 1 (see full paper), I show the Fed’s reduction and eventual slow increase of the Fed Funds rate while house prices were rising quickly. The Fed Funds rate reached a plateau at the peak of the housing bubble, but the Fed was slow to lower the Fed Funds rates as housing prices began to collapse. As long as Fed policy can contribute to forming bubbles in asset prices (and in this case, housing), no simple risk retention rule will protect investors or taxpayers.

Securitization Provisions in the Dodd-Frank Act

Dodd-Frank requires that securitizers retain at least five percent of the risk in all loans that do not qualify as a Qualified Residential Mortgage (QRM)2 and are sold into the securitization market. In theory, five percent risk retention would lead securitizers to be more careful in the loan origination and underwriting process.

To be sure, five percent risk retention would be the simplest approach to implement to encourage improved loan origination and underwriting. Unfortunately, risk retention also appears to be the least useful approach.

First, the house price collapse resulted in house price declines that far exceeded five percent; for example, Las Vegas fell 56 percent from peak to trough.3 [See Figure 1 for the collapse of housing prices]

Second, risk retention does not directly address origination risk.4 Representations (“reps”) and warrants that are found in Mortgage Loan Purchase Agreements (MLPAs) and related documents directly address origination risk. The avalanche of loan repurchase requests in the aftermath of the housing collapse makes reps and warranties less viable for non-agency mortgage-backed securities.

Third, the Federal Housing Administration (FHA), Fannie Mae and Freddie Mac are exempt from risk retention rules. Exempting these players in the mortgage market defeats the spirit of risk retention since a loan originator will be tempted to sell to or be insured by Fannie Mae, Freddie Mac and the FHA rather than keep the retained risk.

Fourth, given Reg AB (Dodd-Frank 942) and the anticipated transparency of the ABS markets, the retention rule implies that Qualified Institutional Buyers (QIBs) are not sophisticated enough to understand origination risks and need to be protected beyond greater transparency. QIBs (or “sophisticated investors”) such as Fannie Mae, Freddie Mac, PIMCO and others do not require the additional security of five percent risk retention since they perform substantial due diligence and analysis before purchasing securities.

In summary, it is unclear how risk retention will be implemented (e.g., vertical versus horizontal versus “L” cuts) and if it is even effective in reducing origination risk.

There are more effective alternatives to risk retention: transparency and improved representations and warranties.


  1. Lawrence H. White, “Federal Reserve Policy and the Housing Bubble,” Cato Journal, Vol. 29, No. 1, Winter 2009,
  2. A qualified residential mortgage (QRM) is one with an 80 percent loan-to-value ratio, full documentation, and more traditional underwriting standards. This generally includes the 30 year fixed-rate mortgage and excludes exotic mortgages such as interest-only mortgages.
  3. Free exchange, “Recovery comes to Las Vegas,” The Economist, January 26, 2010,
  4. Origination risk refers to the risk of breaches of underwriting standards, misrepresentations, fraud, poor data quality and other legal breaches.