As required by Section 941(c) of the Dodd–Frank Wall Street Reform and Consumer Protection Act, the Board of Governors of the Federal Reserve System has conducted a study and issued a report on the effect of the new risk retention requirements to be developed and implemented by the federal agencies, and of Statements of Financial Accounting Standards Nos. 166 and 167 (FAS 166 and 167).
The report provides information and analysis on the impact of various risk retention and incentive alignment practices for individual classes of asset-backed securities both before and after the recent financial crisis. The study defines and focuses on eight loan categories and on asset-backed commercial paper (ABCP). ABCP can be backed by a variety of collateral types but represents a sufficiently distinct structure that it warrants separate consideration.
The study defines and examines by asset class a number of mechanisms that may improve the alignment of incentives, mitigate credit risk, or both. These mechanisms include retention of securities or underlying loans, overcollateralization, subordination, third-party credit enhancement, representations and warranties, and conditional cash flows. All of these mechanisms involve the securitizer, the originator, or some other party to the securitization process retaining an economic exposure to a securitization.
Performance during the crisis varied among asset classes, providing useful evidence on the relative impact of risk retention practices and incentive alignment mechanisms that were in place before the crisis. All asset classes suffered mark-to-market losses during the crisis as investors, and thus liquidity, fled asset-backed securities (ABS). Widespread defaults, in which contractual payments were not made to bondholders, were largely concentrated in ABS backed by real estate. According to the study, these losses appear to be driven primarily by the large drop in nominal house prices and its effect on loans made to borrowers with weak credit histories, unverified income, or with nontraditional amortization structures. The study states in other cases, such as ABS backed by government student loans, losses were driven by certain problems with the prevalent structures—namely, their reliance on short-term funding markets that were disrupted during the crisis.
Overall, the study documents considerable heterogeneity across asset classes in securitization chains, deal structure, and incentive alignment mechanisms in place before or after the financial crisis. Thus, this study concludes that simple credit risk retention rules, applied uniformly across assets of all types, are unlikely to achieve the stated objective of the Dodd-Frank Act—namely, to improve the asset-backed securitization process and protect investors from losses associated with poorly underwritten loans.
Thus, consistent with the flexibility provided in the statute, the Board of Governors of the Federal Reserve System recommends that rule makers consider crafting credit risk retention requirements that are tailored to each major class of securitized assets. Such an approach could recognize differences in market practices and conventions, which in many instances exist for sound reasons related to the inherent nature of the type of asset being securitized. Asset class–specific requirements could also more directly address differences in the fundamental incentive problems characteristic of securitizations of each asset type, some of which became evident only during the crisis.