Defending Skin-in-the-Game: How Regulators Should Structure the Final Credit Risk Retention Rules for the Residential Mortgage Market

Article excerpt


Relaxed lending standards, lending without retaining residual risk, and financial engineering led to a large expansion of mortgage credit that resulted in the over-origination and over-leveraging of poor quality mortgage securities products in the years leading up to the 2008 financial crisis. The over-origination of these poor quality assets has been attributed to a lack of skin-in-the-game by the parties making lending and structuring decisions in the securitization chain. The proposed credit risk retention rules, promulgated pursuant to Section 941 of the Dodd-Frank Act, attempt to fix the flaws in the residential mortgage securitization process that led to the financial crisis by closely aligning the economic interests of parties in the securitization chain, namely by crafting the Qualified Residential Mortgage ("QRM") safe-harbor to risk retention narrowly, and by prohibiting a securitizer from profiting off of a securitization pool that ultimately fails by establishing a premium capture cash reserve account. These proposed rules are currently under attack by a variety of commentators who seek to expand the definition of the QRM safe-harbor and ease other restrictions associated with the proposed rulemaking. This Comment examines the proposed credit risk retention rules as they apply to residential mortgages and considers responses to the rules from consumer advocates, politicians, trade groups, and financiers. In spite of the opposition to the proposed rules, this Comment urges regulators to maintain most elements of the proposed rulemaking, including the narrow QRM definition and restrictions on hedging because they attack certain crucial problems that contributed to the recent financial crisis. However, this Comment proposes a modification of the premium capture cash reserve account concept in a manner that would better encourage private label extension of safe credit.


On October 19, 2011, the Securities and Exchange Commission ("SEC") filed a complaint alleging fraud against Citigroup for its role in structuring and marketing a collateralized debt obligation ("CDO") that derived its value from subprime mortgages.1 Although investors in the CDO lost hundreds of millions of dollars once the subprime bubble burst, it was alleged that Citigroup realized net profits of at least $160 million for arranging the CDO.2 Making matters worse, the complaint alleged that Citigroup selected and marketed $500 million worth of the assets in the CDO without disclosing to investors that it had entered into short positions on those assets by purchasing credit default swaps ("CDS"), thereby placing its economic interests adverse to those of the investors in the CDO.3 Citigroup entered into a settlement agreement with the SEC, agreeing to pay a $285 million fine to squash the complaint, without admitting any wrongdoing.4

Similarly, on April 15, 2010, the SEC filed a complaint alleging fraud against Goldman Sachs for its role in marketing a CDO to investors that derived its value from subprime mortgages.5 Specifically, the complaint alleged that Goldman failed to disclose that a hedge fund with economic interests directly adverse to those of investors in the CDO played a significant role in selecting the assets that collateralized the CDO.6 Investors in the CDO lost over one billion dollars while the hedge fund's CDS exposure to the CDO yielded a profit of approximately one billion dollars.7 Goldman, which did not retain an economic interest in the CDO, collected $15 million from the hedge fund for marketing the CDO to investors.8 Goldman ended up paying a $550 million fine to the SEC to settle this complaint without admitting any wrongdoing or liability.9

These two proceedings exemplify the flaws in the originate-todistribute model of mortgage securitization that helped precipitate the 2008 financial crisis ("Financial Crisis"). Because the parties making lending and structuring decisions in the securitization chain were exposed to minimal credit risk on the underlying loans and received fees in proportion to the size of the deals they created, they were incentivized to cut as many deals as possible, which encouraged shady, and even predatory, lending and structuring practices. …