SF Fed says even modest risk retention will reduce MBS losses

The San Francisco Federal Reserve expects losses on mortgage-backed securities to shrink as lenders retain more risk on loans they securitize under Dodd-Frank. Title IX of the Dodd-Frank Act requires lenders to retain at least 5% of the credit risk on mortgages underlying RMBS. Researchers at the San Francisco Fed said in a paper released Monday that existing MBS deals where the lender held at least an affiliated interest in the performance of those loans had roughly half the losses of those deals where the lender held no “skin in the game.” Wells Fargo (WFC) wrote to regulators in November detailing what sort of risk the San Francisco-based bank is prepared to retain on future MBS packages. Researchers studied the relationship between performance, pricing and losses on a sample of Alt-A MBS. The cumulative net loss rate, which is the loss of principal due to default compared to the original pool balance, on deals where the originator served as the MBS sponsor and servicer experienced “average less than half the rates for mixed or unaffiliated deals.” In mixed deals, sponsors were affiliated with one of several originators in the pool, and with unaffiliated deals, the sponsor was not an originator at all. “Overall, these results suggest significant performance differences based on the loss exposure of the mortgage originator. In short, skin in the game matters for performance,” according to the San Francisco Fed report. Researchers added that because the residual interest retained by the sponsors in the affiliated MBS deals was 3% of the total value of the securitization, researchers concluded that a 5% loss exposure under Dodd-Frank “is likely to have a significant impact on loss rates.” Write to Jon Prior.