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Credit Card Securitization and Skin-in-the-Game

posted by Adam Levitin

I have a new paper on credit card securitization and what it teaches us about the likely effectiveness of the Dodd-Frank Act's skin-in-the-game risk retention requirements. Credit card securitization has long required 4%-7% credit risk retention (cf. 5% under Dodd-Frank).  

I argue that when combined with other features of credit card securitization it was actually counterproductive at aligning issuer/securitizer and investor incentives and likely contributed to rate-jacking. Instead, credit card securitization didn't go off the rails like mortgage securitization because of the existence of implied recourse, effectively 100% skin-in-the-game. This suggests that skin-in-the-game cannot be relied upon as a one-size-fits-all cure. Its effectiveness will instead depend on the other securitization features with which it is combined.  

If you're interested in going into the sausauge factory of credit card securitization, there's plenty of gore and detail here for you. If you're interested in the connections between credit card securitization and rate-jacking, there's something here for you. And if you're interested in whether Dodd-Frank's risk retention requirements will be effective, there's something here for you too.  

The (overly long) abstract is below the break:

The Dodd-Frank Act’s “skin-in-the-game” credit risk retention requirement is the major reform of the securitization market following the housing bubble. Skin-in-the-game mandates that securitizers retain a 5% interest in their securitizations. The premise behind skin-in-the-game is that it will lessen the moral hazard problem endemic to securitization, in which loan originators and securitizers do not bear the risk on the ultimate performance of the loans. 

Skin-in-the-game requirements have long existed in credit card securitizations. Their impact, however, has not been previously examined. This Article argues that credit card securitization solves the moral hazard problem not through the limited risk retention of formal skin-in-the-game requirements, but through implicit recourse to the issuer’s balance sheet. 

Absent this implicit recourse, skin-in-the-game would actually create a severe incentive misalignment between card issuers and investors because card issuers have lopsided upside and downside exposure on their securitized card receivables. The card issuers bear a small fraction of the downside exposure, but retain 100% of the upside, should the card balance generate more income than is necessary to pay the investors. 

The risk/reward imbalance creates a distinct problem because the card issuer retains control over the terms of the credit card accounts. Prior to the Credit CARD Act of 2009, the issuer could increase a portfolio’s volatility through rate-jacking: when interest rates and fees are increased, some accounts will pay more and some will default. Per the Black-Scholes option-pricing model, the increased volatility benefits the issuer because of the risk-reward imbalance. 

Despite the problems posed by the risk-reward imbalance, credit card securitization avoided the excesses of mortgage securitization. The explanation for this is that credit card securitization features complete implicit recourse. Implicit recourse exists because credit card securitization is not about risk transfer, but instead about regulatory capital arbitrage and creating a funding and liquidity source for the issuer. 

The implication of this study is that skin-in-the-game requirements alone may be insufficient to ensure against moral hazard problems in securitization. Instead, the effectiveness of skin-in-the-game is highly dependent on its interaction with other variable features of securitization transactions.

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