Was Avoiding Risk Retention a Pyrrhic Victory for RMBS?

RMBS was the only ABS category that avoided post-crisis risk retention requirements, despite the role that their originate-to-distribute model played in creating the need for deal sponsors to have skin in the game.

They avoided risk retention, according to Barney Frank’s keynote address at the ABS Vegas 2015 conference, because Wall Street’s clout pales next to the influence of an industry that has realtors and mortgage brokers in every single congressional district. This allowed them to carve out an exception for the one asset class that most clearly drove the demand for risk retention.

Avoiding risk retention, however, did not void policy concerns aimed at preventing another residential mortgage meltdown caused by lax underwriting standards. It also did not void AAA investors’ concerns about the originate-to-distribute model, which has prevented the PLS market from coming back. Therefore, the avoidance of risk retention for RMBS may have been a Pyrrhic victory. It appears to have resulted in micromanagement that is satisfying to no one and contributing to a stagnant market. The bottom line may be that without the more comprehensive and flexible protection provided by risk retention, investors and regulators are going to want to second guess every single decision about credit extensions.

At a panel discussion at the ABS East 2017 conference that included Patrick Orr of the CFPB, originators voiced several very legitimate complaints ranging from 1) the perceived nit-pickiness of regulations (e.g., font size on report submissions) to 2) the more serious issue of the uncertainty of originators’ potential liability for trivial deviations from Know Before You Owe guidelines—even those that are done to benefit the borrower.

As valid as these concerns may be, do they result directly from the avoidance of risk retention? The market has to be assured in some way that the abandonment of underwriting standards in the run up to the crisis won’t happen again. As long as risk continues to be transferred away entirely from the institutions making underwriting decisions and investors know they bear 100% of the risk from a complex and opaque underwriting process they don’t control, two things will happen: investors will respond with ever-increasing demands for data, and the government will respond with ever-increasing demands for rigid process controls.

Requiring originators to maintain a portion of the risk would require them to raise massive amounts of capital, and many argue this would be hugely expensive and  result in increased cost to consumers. They are right. But how does it compare to the cost of the alternative? The piper must be paid, one way or the other.