FSOC - White Paper - Macroeconomic Effects of Risk Retention Requirements - January 2011

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January 2011

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) mandated a study on the legislation's risk retention requirements. The study, titled "Macroeconomic Effects of Risk Retention Requirements" was released on January 18, 2011 by the Financial Stability Oversight Council (FSOC).

The Dodd-Frank Act imposes credit risk retention requirements by which securitizers, and in certain circumstances originators of asset-backed securities, "must retain not less than 5 percent of the credit risk for any asset unless the asset is a Qualified Residential Mortgage."

The report also warns that risk-retention requirements which are too stringent may harm lending and negatively impact credit.[1] The study notes that asset-backed securitization provides important economic benefits by improving the availability and affordability of credit to a diverse group of consumers, businesses, and homeowners.

However, as the recent financial crisis demonstrated, without reform, risks in the securitization process can detract from these benefits. Leading up to the recent crisis, originators and securitizers made loans, bundled them together, and then sold them off to a broad array of outside investors, often without retaining a meaningful share of the risk. Because originators had little interest in whether the borrowers would be able to repay the loans, underwriting standards deteriorated and excessively risky mortgages flooded the market. This helped fuel the financial crisis.

To address this serious flaw in the pre-crisis securitization market, the Dodd-Frank Act generally requires that securitizers or originators have “skin in the game” by retaining at least 5 percent of the credit risk of an asset sold to investors through the securitization process, which should allow market participants to price credit risk more accurately and allocate capital more efficiently.

By putting in place such safeguards, the Dodd-Frank Act can help ensure that securitization is a stable and reliable source of credit for consumers, businesses, and homeowners in the United States.

References

  1. Fact Sheet: The Financial Stability Oversight Council Chairman’s Study on “Risk Retention”. US Department of the Treasury. Retrieved on January 21, 2010.

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