The Dodd–Frank Act imposes reforms that are designed to prevent a repeat of the disastrous performance of residential mortgage-backed securities and—less remarked upon—commercial mortgage-backed securities (CMBS) during the financial crisis. Some of these regulations are designed to force issuers of asset-backed securities to have skin in the game—that is, to keep on their own books a slice of the securities they sell and thus retain some of the credit risk associated with the loans underlying the securities. The idea is that an issuer with its own assets at stake has a greater incentive to do its due diligence, and that this stake signals to would-be investors that the issuer also stands to lose money if its securities fail to pay off as promised.
Most residential mortgage securities are exempt from the new rules because their underlying loans already conform to the standards stipulated by the government-sponsored enterprises that buy them. For commercial mortgage securities, however, the regulations are actually binding. But what is the evidence that skin in the game matters? If skin in the game is so important, why don’t the securities markets insist that issuers keep an adequate stake in order to protect investors’ own interests? That is, do issuers actually need a government regulation to ensure that their commercial mortgages are safely designed and that they lend only to creditworthy borrowers? And if such a regulation is needed, are Dodd–Frank’s mortgage securities reforms well crafted?
This article appeared in the First Quarter 2018 edition of Economic Insights. Download and read the full issue.