'Skin In The Game' In The Mortgage Securitization Market Is Bad

A comment I posted on "Research: ‘Skin in the Game’ Is Good for Mortgage Market" on The Wall Street Journal Real Time Economics blog:

Mortgage providers' skin in the game does not reduce any particular borrower's chance of default. A lower credit rated borrower's risk of default is still the same. Skin in the game makes mortgage providers more cautious when lending to a lower credit rated borrower out of fear of losing their working capital to fund new mortgages. With skin in the game, lenders will turn off credit to higher risk borrowers.

Skin in the game appears to work because it denies credit to a whole class of borrowers.

The study [Mortgage-Backed Securities: How Important Is “Skin in the Game”? by Christopher M. James] cited in the article also finds that there was a higher yield to investors on mortgages with higher expected defaults. In other words, the financial markets worked and investors received a higher interest rate for higher risk. The article states:

"The final question is whether investors anticipated performance differences and therefore demanded higher yields or greater credit enhancement for MBS in which originators had less skin in the game. To address this, Demiroglu and James compare the average yield and percentage of securities issued with AAA ratings for affiliated and unaffiliated deals. Controlling for mortgage and borrower risk characteristics, they find average yields are significantly lower on securities in affiliated deals relative to securities in unaffiliated deals. In addition, affiliated deals were able to issue a relatively greater proportion of securities with AAA ratings. These results suggest that investors considered moral hazard when pricing MBS."

Skin in the game goes against many well understood macro-economic and finance principals. The capital available for mortgage lending will shrink significantly and skin in the game will act as a brake on economic activity, possibly causing recessions. The Fed will lose some of its macro-economic power to increase lending during those recessionary times because increasing the money supply will not enable banks to lend more to the housing sector since they will be constrained by a lack of available capital and funds to use for skin in the game requirements.

Skin in the game will also limit financial intuitions' institutions' abilities to diversify their asset holdings. The institutions will be required to retain mortgages and will not be able to decrease that asset class to control and diversify their lending risk. If constrained by skin in the game, the institutions will also not be able to increase that asset class to control risk. Diversification is a fundamental risk control mechanism and skin in the game limitations will create a whole host of currently unforeseen unintended consequences as financial institutions use other means to control, increasing or decreasing, the amount of their mortgage and institutional risk.

The credit rating agencies incorrectly labeled high risk MBS's (also ABS's) as low risk. The incorrectly labeled AAA securities brought in many investors who should not have invested in these securities. The undeserved AAA ratings also allowed banks to hold less capital than needed and regulatory required for the securities' risk. Dodd-Frank removed the power of a Nationally Recognized Statistical Rating Organization (NRSRO) to determine indirectly an asset's required capital level in the banking sector. Financial institutions will no longer be able to hold insufficient capital for an MBS (or ABS) and hide behind a credit rating agencies incorrect AAA analysis of a high-risk MBS security. In addition, Dodd-Frank's elimination of the NRSRO oligopoly has substantially increased the number of competitive credit rating firms.

The NRSRO changes in Dodd-Frank will force banks to increase their capital for higher risk MBS and ABS holdings. These changes will also eliminate the power of undeserved AAA ratings and naïve investors looking for only AAA ratings will no longer find themselves mistakenly holding high risk securities mislabeled as safe.

Skin in the game is a no win situation. It turns off bank credit to a whole class of borrowers. Some portion of these borrowers will turn to other sources of credit and others will go without.

Skin in the game constrains some of the Fed's macro-economic control of lending and the money supply.

Skin in the game constricts a bank's risk control and diversification ability.

Elimination of the NSRSO oligopoly and power over setting an asset's capital requirements solves many, if not most, of the problems associated with excessive high-risk MBS (ABS) securitization.

As the mentioned study shows, higher risk MBS's had higher yields than lower risk MBS's. The securitization market worked as expected and priced the risk. The credit rating agencies failed to accurately rate higher risk securitizations leading some investors to misperceive the risk of their holdings. Financial institutions failed to hold adequate capital for the higher risk MBS's due to the incorrect high credit ratings for the investment.

Dodd-Frank fixed the problems that occurred from high-risk mortgage lending securitizations through changes to NSRSO role and status. Skin in the game adds problems for institutions, borrowers and the Fed without any benefit.

Congress should modify Dodd-Frank to eliminate skin in the game requirements.