The Dodd-Frank Act and Housing Finance: Can It Restore Private Risk Capital to the Securitization Market?

Article excerpt

Private risk capital has virtually disappeared from the U.S. housing finance market since the market's collapse in 2008. This Essay argues that private risk capital is unlikely to return in any scale until the informational problems in housing finance are resolved so that investors can accurately gauge and price the risks they assume.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 represents a first step in reforming U.S. housing finance. It takes a multi-layered approach by regulating both loan origination and securitization. Dodd-Frank's reforms, however, fail to address adequately the opacity of credit-risk information in mortgage markets and thus are insufficient to restore private risk capital.

This Essay argues that such Dodd-Frank reforms as "skin-in-the-game" credit-risk retention fail to solve the informational problems in the housing finance market, as they merely replace one source of informational opacity with another. Instead, this Essay argues, it is necessary to institutionalize structural changes in the housing finance market, particularly the standardization of mortgage securitization, that force the production of information necessary for accurate risk-pricing.

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Introduction ......................................................................................................156

I. Unraveling the Dodd-Frank Act's Regulatory Layers ................................. 160

A. The Defense-in-Depth Approach................. ................................. .160

B. Factors That Will Determine the Success of Dodd-Frank. ...........163

II. The Information Problem in Mortgage Markets ......................................... 165

A. Information Problems in Securitization...... ..................................165

B. Information Problems in Portfolio Lending ................................. 166

C. The Limitations of Risk Retention .................................................167

D. The Limitations of Market Discipline in Informationally Shrouded Markets..........................................................................169

E. The Limitations of Diagnosis from Market Symptoms.................. 172

III. Degrees of Standardization ........................................................................173

Conclusion........................................................................................................ 176

Appendix.......................................................... ................................................. 178

Introduction

The U.S. housing finance system is currently on government life support. In the wake of the housing bubble's collapse, the federal government has stepped into the breach that was created by both the failure of the financial institutions that created the secondary market for mortgage financing and the withdrawal of private risk capital from the housing finance system. Prior to 2008, private risk capital fueled the U.S. housing finance system. Almost all residential mortgages were funded through either the government-sponsored enterprises (GSEs) - Fannie Mae and Freddie Mac - private-label mortgage securitization (PLS), or portfolio lending by depositories.

The GSEs were federally chartered entities owned by private shareholders and were subject to federal oversight. The GSEs purchased mortgages, which they either held in their own portfolios or securitized. The GSEs financed their portfolio operations by issuing widely held corporate debt. The credit risk on the GSEs' mortgage-backed securities (MBS) was retained by the GSEs, which guaranteed their own MBS.1 Private-label securitization involved exclusively private risk capital, with credit risk assumed by investors and private insurers, while the credit risk on loans funded by depositaries was retained by the depositaries. …