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Dodd-Frank: Credit risk will stay after sale

If it’s toxic, you’re vested in it.

That’s the rule shaping up as part of the Dodd-Frank reform law. The measure mandates that regulators develop rules requiring any securitizer to retain at least 5 percent of the credit risk for any asset that is securitized and sold, transferred, or conveyed to a third party.

The FDIC, says Chairman Sheila Bair, is working on an interagency basis to develop standards for risk retention across several asset classes – including requirements for low-risk “Qualifying Residential Mortgages,” or QRMs, that can be exempt from risk retention. Bair spoke recently at the National Conference on the Securities Industry in New York.

“These rules give us a chance to set a ‘gold standard’ for underwriting criteria so that securitization will encourage high-quality mortgages that are sustainable for the long term,” Bair says.

The recent controversy over “robo-signing” by mortgage servicers highlights the unfortunate fact that servicers do not always have the proper economic incentives to make their process as robust and efficient as it needs to be, she says.

Bair has some more to say and points some blame right at the lenders:

“Throughout this crisis, servicers have been too reluctant to modify mortgages, opting instead in too many cases to go through a costly foreclosure process. Meaningful reform of securitization is needed to ensure that servicers have: the authority to act to mitigate losses; the responsibility and the incentives to act for the benefit of all investors; and the oversight to make sure they do the job right.”

The new rules under Dodd-Frank for risk retention and Qualifying Residential Mortgages give federal agencies a unique opportunity to better align the incentives of servicers with those of mortgage pool investors, Bair says. “We believe that risk retention should require issuers – particularly those who also are servicers – to retain a ‘vertical slice’ interest in the mortgage pool that is directly proportional to the value of the pool as a whole.”

The FDIC also believes that the rules for Qualifying Residential Mortgages should require servicers to disclose any ownership interest in other whole loans secured by the same real property, and to have in place processes to deal with any potential conflicts.

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