Securitization Skin-in-the-Game Rules Permit Hedging Stakes

A U.S. government proposal requiring bond issuers or lenders to keep stakes in securitized loans allows the companies to offload some of the retained risk, even as portions of the draft rules prohibit hedging.

Companies packaging loans and leases into bonds will be barred from buying default protection tied to the “particular” asset-backed securities in which they must hold slices, according to the proposal, released for public comment yesterday by the Federal Deposit Insurance Corp. and Federal Reserve.

Regulators said the rule, designed to curb dangerous lending, permits other hedging tactics, potentially reducing how much the regulation will depress the flow of credit. Congress mandated last year that agencies create the provisions, reflecting a view that a lack of skin in the game among lenders and bond issuers helped fuel the shoddy mortgages that sparked collapses in housing and financial markets.

“That the institutions can do a variety of hedging almost negates all the advantages,” said Anthony Sanders, a professor of real estate finance at George Mason University in Fairfax, Virginia, and former head of mortgage-bond research at Deutsche Bank AG. “Risk-retention may not make a lick of difference if the bank in question can hedge out most of the risk.”

Companies will be able to use derivatives and other hedging instruments tied to “overall market movements,” such as in currencies, home prices or a “broad category of asset-backed securities,” according to the proposal. They could also buy default protection on “similar assets originated and securitized by other sponsors.”


Under the rule, firms could purchase credit-default swaps referencing indexes of bonds that include the ones they keep parts of as long as classes of their securitizations represent no more than 20 percent of the benchmark, according to the draft. That could include so-called ABX indexes tied to subprime mortgages, regulators said.

Credit-default swaps on structured-finance securities offer payments if the debt isn’t repaid on schedule, in return for regular insurance-like premiums.

Last year’s Dodd-Frank financial overhaul law directed regulators to write the rule, saying the agencies should “prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain.” Issuers must generally retain at least 5 percent of risk, according to the rules.

‘Tie the Hands’

It would be misguided for regulators to “tie the hands” of individual banks that decide they want to shed risk after building up sizable amounts of securitization stakes, said Clifford Rossi, a former senior risk officer at Countrywide Financial Corp., Washington Mutual Inc. and Citigroup Inc.

“At the same time, if every institution takes this view, then you solve for nothing in trying to shut down systemic risks from building up,” said Rossi, now executive-in-residence at the University of Maryland’s Center for Financial Policy in College Park.

Before the market for bonds backed by riskier U.S. home loans shut in 2008, banks including Goldman Sachs Group Inc. and Deutsche Bank bought protection in the credit-default swap market even as they sold new mortgage-linked securities. That helped offset later losses from debt held on their balance sheets, the companies have said.

Merrill Lynch & Co., UBS AG and Citigroup were among banks whose hedges against defaults on specific mortgage-tied securities failed during the crisis as the creditworthiness of the bond insurers providing protection collapsed.

Bear Stearns, Goldman

Some investment banks hedged in equity markets as the crisis grew. In late 2007, Bear Stearns Cos. bet against the shares of banks that bought default protection from Ambac Assurance Corp., the debt guarantor said this year in a lawsuit, citing internal e-mails. A Goldman Sachs trader that year also recommended his firm wager against Bear Stearns’s shares, according to e-mails cited at a Senate hearing last year.

Yesterday’s proposal includes risk-retention exemptions for certain high-quality residential mortgages, as well as for commercial-mortgage securitizations in which a third-party firm buys the riskiest slices after reviewing the loans. Hedging rules for those commercial-mortgage investors, known as B-piece buyers, are similar to the regulations intended for banks and issuers.

Hedging Bets

In one period before defaults soared, more than half the buyers of the riskiest slices of collateralized debt obligations used to repackage home-loan securities paired those purchases with other wagers that mortgages would default, according to the final report of the Financial Crisis Inquiry Commission.

Purchasers of the riskiest portions of mortgage bonds that weren’t placed into CDOs also often entered into “short” bets against home-loan debt, the panel said. The buyers of these slices had traditionally worked to monitor the credit risk of the deals, so “it was no longer clear who -- if anyone -- had that incentive,” the FCIC said.

The type of hedging allowed by yesterday’s proposal would encourage issuers to make loans in their deals better than those of competitors, said Dan Castro, head of structured finance strategy at BTIG LLC in New York. Higher-quality debt would outperform hedges tied to the broader market in either good times or bad, he said.

“That’s just the way the math works,” Castro said.

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