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Skin in the Game

posted by Adam Levitin

The proposed skin-in-the-game requirement for securitization strikes me as misguided, no matter how its structured. Different industries use securitization for different purposes, and while skin in the game might not have much of an impact in some, it runs contrary to the (legitimate) purposes of securitization in others.

Some industries securitize primarily to gain off-balance sheet and immediate revenue-booking accounting benefits and because it is a cheaper funding source than other methods. Industries like these often have significant skin in the game (e.g., the credit card industry, where a 7% vertical slice is the typical minimum requirement and it's usually much higher). Other industries, like non-GSE mortgages securitize primarily to shift credit risk. The whole point of securitization is not to have skin in the game.

The skin in the game requirement is being driven by the experience in mortgage securitization, not other types of securitization, and imposing a skin in the game requirement probably won't do much to non-mortgage securitization, where there might already be more than 5% retained interest. But for housing finance, skin in the game is really counter productive.

Most mortgages are originated either by thinly capitalized mortgage banks and brokers or by depositary institutions. Mortgage banks and brokers simply cannot afford to have skin in the game--their business model is not based on holding credit and interest rate risk beyond what product they have warehoused before securitizing it. And depositary institutions are ill-suited for holding the interest rate risk on long-term fixed-rate mortgages. This is the lesson we ought to have learned from the S&L crisis: if interest rates go up, depositary institutions that hold long-term fixed-rate obligations take a beating, as their cost of funds can exceed the yield on the mortgages.

If we want to do long-term fixed-rate mortgages (and we should, as consumers are not well equipped to handle interest rate risk), we need to match long-term funders (insurance companies, pension plans, etc.) with long-term borrowers. The long-term funders don't do mortgage origination (insurance companies used to, but they got out of the market for reasons I don't understand), so we need the secondary market (securitization) to match them with the long-term borrowers. Making depositary institutions sit on a chunk of the loan is just counterproductive--it places interest rate risk on institutions that we know can't handle it--rather than placing it with institutions that are happy to take the risk in exchange for a locked-in, long-term fixed-rate of return.

The problems that arose with private-label securitization were primarily from information asymmetries between MBS purchasers and originators. The ratings agencies were supposed to bridge that divide, but the nature of private-label MBS was that they were heterogenous products, and the whole ratings system is based on past performance, which requires homogenous products with known track records. Not possible for new niche products. (fwiw, the niche products were only able to gain market share because of information asymmetries between originators and consumers. If the full cost of the niche products was clear up-front, they could not compete against the 30-year fixed, which benefitted from the implicit government guarantee of the GSEs; the only way private-label products could compete was through cost obfuscation via complexity.) Private-label MBS can work, but product standardization both of the mortgages and the MBS are essential for correcting the information asymmetries that originators exploiting during the bubble. Skin in the game is just an awkward and counterproductive way of dealing with the information asymmetries that could be more easily corrected through policies that favor the 30-year fixed as the standard product for securitization.

Where skin in the game actually make sense is not with originators, but with servicers. This crisis has taught us about the importance of servicers in loan performance, and servicer compensation needs to be revised so that servicers have incentives that match all investors' (something like a vertical slice). Watch for more on this later this summer.


The skin in the game requirement is misguided because it focuses on the wrong malfeasor. The originators were just the pawns of the investment bankers --- bought and paid for with no-risk front-end payouts. Their culpability is minor compared to the Wall Street wizards, who orchestrated the scheme and profited mightily by obfuscating the truth about the risk of tranched subprimes, with the complicity of the rating agencies, of course. As I understand it, the rating agencies are no longer permitted to earn a large fee contingent upon giving a security a good rating. The skin in the game requirement should be imposed on the securitizer, probably in the form of a partial guarantee. If they are going to package and sell junk debt, they ought to bear the risk of it going bad. This is only a partial solution, however. There needs to be some form of personal liability for the wizards themselves. To date, no one has bothered to ask the ones who made millions whether they regret what they did. The allure of great personal wealth is the real "moral hazard" that has yet to be dealt with. Up until now, the investment bankers have been trusted to act like fiduciaries for the financial system. They've now proven that they cannot be trusted to put the good of the system ahead of their own bonuses.

Just found this blog today. Your note is interesting, but I'm skeptical of a big change taking place based on either originators or servicers having skin in the game. In the commercial mortgage market, the servicers almost always retain the subordinate pieces. It hasn't helped that market very much (although I would note that a vertical slice would be preferable to a subordinate tranche, i don't think it would have made much of a difference here). Also, regarding the prior comment, in the residential market, there were many firms that retained whole loans and still got hit hard (Wachovia and Washington Mutual come to mind). While it makes sense that retaining more risk should make the firms better underwriters, it is not necessarily true. Finally, standardization of terms for mortgages would not be a panacea either. There have been many 30-year fixed rate loans originated with falsified income against an inflated home value. I'm not saying I have an answer, just that the problem is extremely complicated and I don't think the proposals currently on the table would prevent a bubble from happening.

Dear Professor Levitin,
Mortgage servicers have had more than enough 'skin in the game' over past 20 years, mine and that of millions of other homeowner victims of mortgage servicing fraud. Mortgage servicing compensation is what it is, often including a slice of foreclosure sale profit and any and all bogus fees they can collect from hapless homeowners, all neatly laid out in PSAs. If servicers don't like what is offered them, then my advice is don't be a mortgage servicer. I am shocked that someone with your credentials would suggest that servicers need greater financial reward in order to do an honest job. Professor Levitin, This crisis has certainly taught all too many of us about the importance of servicers in loan performance. On this point I wholeheartedly agree.

Blossom, I think you misunderstand what skin-in-the-game means and how I'm suggesting it apply to servicers. I'm not suggesting that they be paid more, but rather that they be paid differently. I certainly get the problems with servicer compensation. I was one of the first people to say that mortgage servicers frequently have perverse economic incentives that encourage them to foreclose even when the best deal for investors and the homeowner would be a loan restructuring; I recorded a radio interview with Marketplace in early summer 2008 on this that didn't get aired until winter 2009, and I was saying this is Congressional testimony and other media appearances in the fall of 2008. I don't think that servicers need a greater reward to do an honest job. I think they need a differently structured award to do an honest job. The Making Home Affordable program has only increased their reward (basically a modification bounty), but in doing so, it recognizes the servicer compensation problems. At its heart, the problem is that servicers' compensation does not currently depend on loan performance,. That's a recipe for trouble, and one way to fix it is to have at least part of servicer's compensation be in the form of non-tranched MBS coupons (a vertical slice). First loss positions can distort and/or be wiped out too easily.

Nick--the CMBS market does servicing differently--there's almost always a special default servicer, whose compensation and incentives are different from the regular servicer. CMBS also hasn't had the workout problems of RMBS, not least because there's a bankruptcy option for CMBS (see General Growth). The problems in the CMBS market really aren't servicing problems, but from a commercial RE market that is scaled to a bigger and hotter economy than today. Sadly, there's nothing that's really going to help CMBS short of a general economic recovery.

Interesting point about the problems with portfolio loans for Wachovia and WaMU, although in both cases, the major portfolio problems were from exotic products, I think--one of them swallowed Golden West with its arsenal of pay-option ARMs. Worth noting, however, that for Fannie/Freddie, the problems were the securitized loans with credit guarantees, not the portfolio loans. And credit unions that kept whole loans haven't run into fatal problems by and large.

I agree that retained risk doesn't necessarily produce better underwriting; but in general it is likely to encourage it. When fraud is involved, the product type is irrelevant; all underwriting becomes suspect, but for honestly underwritten mortgages, the 30-year fixed is a great product. It becomes the rock on which family finances are based, it gives middle class families access to long-term capital, it spares consumers interest rate risk, and it is predictable in its performance. That's a really good deal.


Thanks very much for the well stated response. I do disagree on one point:

I would argue the problems in the CMBS market are not entirely due to being scaled to a bigger economy. The CMBS special servicers are the ones that own the bottom pieces of the deals. They also have the right to kick individual loans out of the trusts before securitization. While the older vintage loans are simply suffering from not being able to refinance, the recent vintage loans ('06-07) were underwritten to unrealistic assumptions (ever rising rents and occupancies - similar to residential loans being written to ever rising house prices). Even an economic recovery won't help these loans in this regard. The special servicers were supposed to be the gatekeepers in the CMBS market and they failed, which is why I'm pessimistic on regulatory reform making a big difference.

I agree that, in theory, retained risk should encourage better underwriting, and in any case certainly shouldn't make it worse. However, in practice, there are, I would say more than a few instances where it hasn't made much of a difference at all. I hope people aren't thinking that this is going to be some magical fix for the financial markets.

Professor, what is it going to take for anyone in a regulatory position to recognize that servicers "have perverse economic incentives that encourage them to foreclose"? I know Mortgage Servicing Fraud victims that have been absolutely SCREAMING about this problem for well beyond 15 YEARS at this point. I, myself, have only been pointing this "perverse incentive" out to anyone that would listen to me since I first began my education about the securitization process five or six years ago.

Senators refuse to listen. Congresspeople refuse to listen. I know Mortgage Servicing Fraud victims that have been and are being turned down left and right by FBI, Secret Service, US Postal Inspector, HUD-OIG, DOJ and entire Mortgage Fraud Task Forces despite having hard, irrefutable evidence of mail fraud, wire fraud, fraudulent/manufactured documents and RESPA, TILA and/or FDCPA violations all over the place. In fact, it is becoming more and more apparent that the federal agencies empowered to bring criminal charges are only bringing them in cases of fraudulent activity AGAINST lenders/originators. Granted, it's a wide world out there, but I have yet to hear of any criminal charges being brought AGAINST a mortgage servicer despite the overwhelming evidence of criminal behavior. In fact, the CRIMINAL investigation that HUD-OIG began involving Fairbanks Capital n/k/a Select Portfolio Servicing back in 2003 or so was apparently terminated when the CIVIL settlement was reached. If I remember correctly, this was despite having at least one "cooperating witness" testify that Fairbanks required what amounted to kickbacks from force placed insurance providers. I believe this "witness" also stated that this was an industry-wide practice and not limited to Fairbanks/SPS' operation. Again, if I remember correctly, another "cooperating witness" claimed that Fairbanks required as much as a 15% "recoupment" fee, I believe was the term used, for REO properties. Maybe I'm confused and the 15% was for the force placed insurance. I'll have to confirm that when I've had more sleep.

In my own, uneducated opinion, the Making Home Affordable program is almost as much of a joke as HOPE Now. If I remember correctly, on top of all of the fees that they already pile onto a borrower - regardless of whether the borrower is legitimately in default or the servicer manufactured the default, with the MHA program. servicers stand to be rewarded with as much as an additional $4500.00 PER LOAN that they modify and allow to remain "performing" for a three (?) year period. IF I remember the breakdown correctly, servicers are awarded $1000 for initiating a modification, $1000 per year for up top three years that a loan remains "performing" once the loan is in the MHA program, and an additional $500 for doing something else, the exact nature of that reward escapes me at the moment. One of the more humorous statistics I think I remember being bandied about was that 50,000 "applications" had been accepted by the MHA program and everyone thought that that was just wonderful. APPLICATIONS. Not MODIFICATIONS made but applications FOR modification. 50k APPS is a far cry from 50k mods MADE.

Now, depending on the terms of the individual PSA, servicers ALREADY get to charge AND pocket "modification" fees if/when they ever allow a borrower to modify a loan. These fees are paid directly by the borrower. That being the case, WHY do servicers need ADDITIONAL financial "incentive" to do their damn job properly and, more importantly, LEGALLY in the first place? Maybe if we tried CRIMINAL PROSECUTION as a deterrent instead of throwing MONEY at the problem, servicers would take their jobs a tad more seriously. Because until they actually have something to LOSE, any CIVIL penalties that can be brought against them is looked at as nothing more than the cost of doing business.

WHEN is some one or some entity going to actually stand up for the BORROWERS that are systematically being SCREWED by servicers? If/when that ever happens, I guarantee that the foreclosure numbers will begin to at LEAST slow down to a more "reasonable" pace. I'm already hearing anecdotal reports of MERS foreclosures essentially disappearing from judicial foreclosure state dockets because MERS is being systematically spanked in court room after court room because the rest of the world has finally come to the realization that Article 3 of the UCC Code really DOES exist and SHOULD be enforced and isn't there merely to take up pages between Articles 2 and 4.

Fortunately, it is becoming more and more common to see it applied. Again, if I remember correctly, Judge Richard Long's recent decisions overturned two year old foreclosure sales for lack of standing http://homeequitytheft.blogspot.com/2009/06/massachusetts-court-ruling-gums-up.html#links . At 2am I may be off in my recollection but I believe it involved at least one of these cases.

Whether case law will be enough to begin to stem this tide remains to be seen but unless servicers have more to LOSE than to GAIN all of the case law in the world isn't going to stop them because they only have to answer for their actions in cases that make it into a court room - which are few and far between. And THAT is what they count on. Maybe if they were at risk of criminal prosecution as well as civil penalty things would begin to change. We'll never find out until/unless it is actually tried though.

The question that has stood for so long is simply "When will that time come?"

Professor Levitin,

No, I do not misunderstand what skin-in-the-game means. Perhaps, albeit with a degree of sarcasm, it seemed urgent to emphasize roll of mortgage servicing
fraud in this debacle. You see, any perceived coddling of mortgage servicers just makes my blood boil.

To suggest that servicers need differently structured compensation in order to conduct their business legally, ethically and honestly, to my thinking sounds
naive, if not 'cart before the horse' or holding out some sort of 'carrot' to bogus fee hungry servicers. What guarantee would this offer that servicers would
suddenly, overnight change their long established egregious ways? How would ongoing, accurate oversight auditing be attained? Rather than restructured compensation in the form of skin-in-the-game incentive, it's time regulatory authorities get out a stick, a very big stick and use it to bring criminal servicers into line.

Despite Federal Trade Commission settlements, touted to be 'industry reforming' real oversight or regulation of the parties claiming "no admission of guilt" remain to be seen.
http://www.ftc.gov/os/caselist/0323014.shtm FTC v. Fairbanks/SelectPortfolioServicing
http://www.ftc.gov/os/caselist/0623031/index.shtm FTC v. EMC/Bear Stearns

Now, adding insult to injury comes the doling out of TARP funds to mortgage servicers including these very same perpetrators. Granted these government funds going to mortgage servicers are purportedly to fund programs to assist troubled borrowers seeking to modify their mortgages and avoid foreclosure but all too many of these troubled borrowers found themselves in the undesirable position of facing foreclosure due to mortgage servicing fraud in the first place. So now they get paid to correct the error of their ways, pro tem that is, until they can restart the vicious predatory cycle all over again.

It's no huge leap to view notions of restructured compensation along with TARP bailouts as rewarding these evil doers, when an obvious corrective solution would be to stop mortgage servicing abuse in its tracks. In light of toothless FTC settlements, one would think some form of servicer audit, report card or servicer fraud test would be required before going forward with any proposals aimed at correcting their behavior. While considering such, let's not forget that these servicers aren't stand alone entities, most being subsidiaries of large investment banks. Instead of congressional lip service, what's called for is modern day Pecora Commission to determine why parent banks' directed and condoned such servicer malfeasance and to what extent insider knowledge of such activity spawned subprime profiteering in credit default swap bets.

Until there is complete understanding of what went wrong with perpetrators identified, we can't begin to fix it. Servicers were complicit in the scheme and shouldn't be coddled into best business practices or rewarded in any way. Anything short of competent, thorough investigation and prosecution if appropriate before proceeding with corrective measures is just kicking the can down the road.

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