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NYT: FDIC to meet Tuesday on ‘skin in the game’

The board of the Federal Deposit Insurance Corporation will meet Tuesday to discuss when trusts that sell asset-backed securities will have to retain some of the risk themselves, according to a March 27 column by Gretchen Morgenson in The New York Times.

RepoWatch tracks news on asset-backed securities because they were among the repo collateral that caused the financial panic in 2007-2008, and the quality of future collateral will be an important repo issue.

The Dodd-Frank Act wants to require some risk retention of risky loans as an incentive for trusts to care about the quality of loans underlying the securities they sell.

Anything that improves loan quality should also improve the quality of repo collateral. But in the past decade banks retained plenty of risk, and that didn’t head off the financial panic of 2007-2008. Banks held one-fourth of the asset-backed securities themselves, and used many of them as collateral for repo loans.

The crisis was not caused by banks selling mortgage risk to investors, through the originate-to-distribute process. It was caused by banks having too much skin in a game based on lousy collateral.

Still, Dodd-Frank wants 5 percent risk retention for risky mortgage securities, while trusts that issue asset-backed securities backed by “qualified residential mortgages” will not have to retain any risk. Now the FDIC has to define that term.

Among the issues the FDIC board will discuss Tuesday, according to Morgenson, are how much of a down payment should be required in a qualified loan, and whether loans with smaller down payments can be elevated to “qualified” with mortgage insurance.

From Morgenson’s column:

The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured.

But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans. Lengthy litigation between the parties is under way but has by no means concluded.

Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington.

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