What Is Credit Risk Retention?
Credit risk retention is a regulatory requirement mandating that securitizers, such as banks or financial institutions, maintain a portion of the credit risk of the assets they pool and sell as asset-backed securities (ABS). This mechanism, falling under the broader category of Securitization within financial regulation, aims to align the interests of the originator or sponsor of a securitization with those of the investors. By requiring the securitizer to have "skin in the game," credit risk retention incentivizes thorough underwriting and sound loan origination practices, reducing the likelihood of transferring poorly performing assets to investors.
History and Origin
The concept of credit risk retention gained significant prominence following the 2008 Financial Crisis, which exposed severe breakdowns in the securitization markets, particularly concerning mortgage-backed securities. A key issue identified was the "originate-to-distribute" model, where lenders had little incentive to ensure loan quality since they quickly sold off the loans and their associated risks to investors.21
In response, Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) mandated that federal agencies, including the Securities and Exchange Commission (SEC) and various banking and housing agencies, jointly develop rules requiring securitizers to retain a portion of the credit risk.20,19 The joint final rule on credit risk retention was adopted in October 2014 and became effective in December 2015 for residential mortgage-backed securitizations and in December 2016 for all other securitization types.18 These rules generally require securitizers to retain at least 5% of the credit risk of the assets collateralizing the ABS issuance.17
Key Takeaways
- Credit risk retention requires securitizers to hold an economic interest in the assets they securitize.
- It was mandated by the Dodd-Frank Act to address issues identified during the 2008 financial crisis.
- The primary goal is to align the interests of securitizers with those of investors, promoting better asset quality.
- Generally, a minimum of 5% of the credit risk must be retained, though exemptions exist for certain high-quality assets.16
- Retention can take various forms, including horizontal, vertical, or a combination of interests in the securitized pool.15
Interpreting Credit Risk Retention
Credit risk retention is fundamentally about incentive alignment and risk management. When a securitizer retains a portion of the default risk in a securitized pool, they share in potential losses alongside investors. This "skin in the game" encourages the securitizer to perform thorough due diligence on the underlying assets and ensure robust underwriting standards during the loan origination process. The retained interest can manifest as a "horizontal" slice (a first-loss position, absorbing initial losses) or a "vertical" slice (a pro-rata share of all tranches in the securitization).14 The presence of credit risk retention signifies a regulatory effort to enhance market discipline and investor protection in the securitization market.
Hypothetical Example
Consider a hypothetical financial institution, "Global Mortgage Bank," which originates $100 million in residential mortgages. Instead of holding these mortgages on its balance sheet, Global Mortgage Bank decides to pool them and create mortgage-backed securities (MBS) to sell to investors in the capital markets.
Under credit risk retention rules, Global Mortgage Bank, as the securitizer, must retain a portion of the credit risk. If the rule requires 5% retention, Global Mortgage Bank could choose to retain a "horizontal residual interest." This would mean holding the most junior, or "first-loss," tranche of the MBS. If the total value of the MBS is $100 million, the bank would retain a $5 million slice of this junior tranche.
In this scenario, if some of the underlying mortgages default, the losses would first hit Global Mortgage Bank's retained $5 million interest before affecting the senior tranches held by investors. This gives Global Mortgage Bank a strong incentive to ensure that only high-quality mortgages are included in the securitization pool, as any defaults directly impact their retained capital.
Practical Applications
Credit risk retention is a cornerstone of post-crisis regulatory compliance in the securitization industry. Its practical applications are broad, affecting various types of asset-backed securities and market participants:
- Mortgage-Backed Securities (MBS): It significantly impacts the origination and securitization of residential and commercial mortgages, aiming to prevent a recurrence of the underwriting failures seen before the 2008 crisis.
- Asset-Backed Securities (ABS): Beyond mortgages, the rules apply to a wide array of securitized assets, including auto loans, student loans, and credit card receivables, requiring securitizers of these pools to hold a portion of the risk.
- Market Discipline: By requiring securitizers to retain a financial stake, the rules aim to restore market discipline, encouraging better risk management and due diligence during the origination and pooling process. The implementation of risk retention requirements has been associated with securitized loans being safer, although potentially at a higher cost to borrowers.13
- Capital Markets Structure: It influences how financial institutions structure securitization deals, often leading to the creation of specific retention tranches or interests that are held by the securitizer. S&P Global Ratings notes that banks are increasingly using synthetic risk transfers (SRTs) to manage their capital and risk profiles, which involves unloading junior tranches of loan portfolios to third-party investors while retaining senior portions.12
Limitations and Criticisms
While credit risk retention aims to improve market stability and investor protection, it has faced various limitations and criticisms since its implementation. One primary critique is that the rules, despite their intent, might not go far enough to prevent excessive risk-taking, or that they could be circumvented.11
For example, critics suggest that broad exemptions for certain types of high-quality assets, like qualified residential mortgages (QRMs), might reduce the overall impact of the rules.10,9 There have also been legal challenges to the application of these rules, particularly concerning complex structures like collateralized loan obligations (CLOs), where courts have sometimes limited the scope of who is considered a "securitizer" obligated to retain risk.8 Some argue that these rules may not fully eliminate the moral hazard inherent when originators transfer assets.7 Furthermore, some analysts suggest that the rules might have contributed to increased costs for borrowers or reduced the availability of credit for certain types of loans, especially those that do not qualify for exemptions.6 The effectiveness of the rules in truly making securitized assets safer for investors while maintaining broad access to credit remains a subject of ongoing debate and analysis.5
Credit Risk Retention vs. Moral Hazard
Credit risk retention is a regulatory mechanism designed to counteract the problem of Moral Hazard in financial markets, particularly within securitization.
Moral hazard, in this context, refers to the increased incentive for a party (like a loan originator) to take on excessive risks or act against the best interests of another party (investors) when the costs of those risks are borne by others. Before risk retention rules, originators could make loans with lax underwriting standards, package them into asset-backed securities, and sell them off without retaining any responsibility for their performance. This created a moral hazard where the originator benefited from the fees of loan origination without bearing the subsequent default risk.
Credit risk retention directly addresses this by forcing securitizers to retain a financial interest, typically 5%, in the assets they sell. This retained interest means the securitizer shares in potential losses if the underlying assets perform poorly. By having "skin in the game," the securitizer's incentives become more aligned with the investors, thereby mitigating the moral hazard that can arise from the originate-to-distribute model.
FAQs
Why was credit risk retention introduced?
Credit risk retention was introduced primarily through the Dodd-Frank Act following the 2008 Financial Crisis. Its main purpose was to prevent a recurrence of the systemic issues caused by lenders originating loans without adequate underwriting standards, as they could quickly sell off the credit risk to investors without consequence.4
What is the typical percentage for credit risk retention?
The typical percentage required for credit risk retention under the Dodd-Frank Act is not less than 5% of the credit risk of the assets collateralizing the asset-backed securities.3 However, specific exemptions and methods of retention can vary.
Does credit risk retention apply to all types of securitizations?
Credit risk retention rules generally apply to most types of securitization transactions. However, there are specific exemptions, such as for certain high-quality mortgage-backed securities (known as Qualified Residential Mortgages or QRMs) and some qualified commercial or auto loans that meet stringent underwriting standards.2,1
How does credit risk retention benefit investors?
Credit risk retention benefits investors by ensuring that the securitizer retains a financial stake in the performance of the underlying assets. This alignment of interests provides an incentive for the securitizer to perform thorough due diligence and maintain higher loan origination standards, potentially leading to a securitized pool with better asset quality and reduced default risk.