Dodd-Frank, True Sale & Skin in the Game (Update 1)

Update 1 (See comment from counsel at end) -- Wall Street is playing a trump card in the continuing battle over financial regulation and the 2010 Dodd-Frank law, namely trying to get rid of rules that require banks to have “skin in the game” when they sell mortgage-backed bonds to investors. 

Nick Timiraos and Alan Zibel of The Wall Street Journal report that regulators: 

“[A]re concerned that tougher mortgage rules for banks could hamper the housing recovery. The watchdogs, which include the Federal Reserve and Federal Deposit Insurance Corp., want to loosen a proposed requirement that banks retain a portion of the mortgage securities they sell to investors, according to people familiar with the situation.”

One has to wonder, however, whether either members of Congress or regulators truly understand the problems created by the Dodd-Frank law when it comes to mortgage finance and loan sales.  First and foremost, the concept of “skin in the game” as embodied in Dodd-Frank is ridiculous to anyone who works in the mortgage business.  Companies that originate loans and sell securities to investors already have extensive exposure to these deals – even when the loans are truly sold to a third party.  The trouble from a public policy perspective is that nobody in Washington has the courage to enforce civil and criminal penalties for securities fraud, thus we have convoluted economic “solutions” like risk retention.    

All lenders who are also sponsors of mortgage bonds have liability to investors in the form of the representations and warranties that they make at the time of the sale.  Dodd-Frank simply added an additional layer of economic exposure, a tax really, on top of the legal and economic “tail risk” that all issuers of mortgage bonds already face. Just look at the massive litigation involving Countrywide and other banks to see the economic reality of “skin in the game” in the mortgage business.  These same exposures were mostly extinguished in bankruptcy for the parent companies for insured depositories like Lehman Brothers Bank FSB and WaMu, of note.

When a bank writes you a mortgage and then “sells” the loan to government housing agency, the loan disappears from the bank’s balance sheet – even if the bank still services the loan.  The “sale” takes place under exemptions to the Dodd-Frank law for US agency loans.  For private investors, however, issuing new mortgage securities with the Dodd-Frank “skin-in-the-game” rules in place is problematic.  Instead of qualifying as a “true sale,” these bonds arguably should be considered collateralized borrowings and must stay on the bank’s balance sheet.  See my earlier comment in ZH on true sale, “Zombie Love…”

“In September 2010, the FDIC amended its safe harbor for securitizations by banks—the FDIC clarified that in a receivership of an insured depository institution, it would not seek to repudiate any asset transfer as burdensome if the securitization met certain criteria,” notes a comment on Dodd-Frank by Shearman & Sterling. “These safe harbor criteria go beyond the usual requirements for a true sale, requiring that securitizations be subject to risk retention, reporting, and disclosure requirements, and, in some cases, requirements for simplified structures.”  

But the more subtle reality of the Dodd-Frank law is that the “skin-in-the-game,” risk retention provisions themselves arguably made it impossible for new, privately-backed mortgage securities to qualify as “true sales” under US accounting rules.  Given the greatly enhanced new receivership powers of the FDIC in Dodd-Frank, investors can forget about the legal isolation standard required by Moody’s and S&P.  The transaction envisioned by the architects of Dodd-Frank is, at best, a heavily qualified secured borrowing.  

Since there have been few private mortgage bonds floated since 2007 and since the Dodd-Frank rules on skin-in-the-game don’t take effect until January 2014, most observers have not really considered this issue – both in terms of securities markets and also from a macroeconomic perspective for housing finance.  Notice that the Nomura private label RMBS deal that just came to market has no explicit retained interest as per Dodd-Frank. Other prime RMBS deals done by Redwood Trust and other issuers do have some retained subordinate interest.  Sadly, none of the offering documents and most important, legal opinions, for these deals are publicly disclosed.  

For now, the legal profession serving the loan and securities industry seems to have convinced themselves that the “true sale” issue is not a problem.  In rule making for swaps related to Dodd-Frank by the SEC, the firm of Sullivan & Cromwell opines optimistically that:

"The Commissions acknowledged types of loan participations offered in the market today – LSTA-style participations [The Loan Syndications and Trading Association]. and LMA-style participations [Loan Market Association].  An LSTA-style participation provides for the sale of the underlying loan by the grantor and a purchase by the participant, which is “intended to effect a ‘true sale’ of the loan from the grantor to the participation and put the participant’s beneficial ownership interest in the loan beyond the reach of the grantor’s bankruptcy estate.” 

The problem, of course, is that statements by well-intentioned professional bodies like the LSTA and LMA operating in the loan trading markets will not offset the considerable legal precedents in the US regarding secured borrowings, collateral and fraud. Specifically, if the FDIC decides to void loan sale agreements or in the event of a sponsor bankruptcy, it is far from clear that the “intended sale” described by Sullivan & Cromwell will survive attack by sponsor creditors much less by the FDIC acting as receiver of a dead bank.  This is why, we should recall, JPMorgan was incented to reaffirm the covered bonds issued by WaMu when the FDIC sold that bank.     

Rep. Scott Garrett (R-NJ) has long championed legislation to allow US banks to issue a form of collateralized borrowing known as “covered bonds,” this to help revive the mortgage market.  One wonders if Rep Garrett and his supporters in Congress understand, however, that the risk retention rules in the Dodd-Frank legislation effectively make it mandatory for banks and non-banks operating outside the federal agency mortgage market to issue only covered bonds.  The provisions of Dodd-Frank supposedly intended to prevent future bad acts in the private mortgage market by requiring issuers to retain an interest in the security arguably makes it impossible for these deals to qualify as “true sales.”

Why is this important?  When a US government agency purchases a loan from a bank, they are increasing the leverage to the economy.  How? By giving the bank back its money so that another loan can be made.  (Watch the Frank Capra film “It’s a Wonderful Life” if you have not already done so.)  With the skin-in-the-game provisions of Dodd-Frank, however, it is virtually impossible for issuers of private mortgage securities to add any leverage to the US economy.  The best that a covered bond will do is give investors some comfort with regards to the quality of the collateral behind the security, but the covered bond remains on the balance sheet of the bank. 

Note that even with the new safe harbor guidance from FDIC, the bank deposit insurer will only tolerate 2% over-collateralization on a covered bond.  So if 2% excess collateral in a private RMBS trust is the limit for FDIC not to reject the sales contract for the loans, we are talking prime collateral that would normally (and most probably) be sold into the agency markets.  The covered bond model espoused by Rep Garrett offers nothing to those who are worried about the housing market and credit availability. In a covered bond model, no additional liquidity is available to the real estate markets or the US economy.  

My friend former FDIC Chairman Sheila Bair, like most regulators, thinks that the skin-in-the-game provisions of Dodd-Frank are a step in the right direction, but I think they are mistaken in this instance.  The WSJ quotes her on this issue: “"My sense is that Washington has lost its political will for serious reform of the securitization market." No, Washington has reformed the private securitization market and with disastrous results.  It is not even clear to me whether the sponsors of the legislation or regulators (including FDIC, sad to say) understand the “true sale” issue in relation to Dodd-Frank and private RMBS.    

If you look at the private label RMBS deals done since 2010, none of them have the specific retained interest provisions required by Dodd-Frank which go into effect in 2014. In the view of many securities lawyers (none of whom will discuss this issue publicly), it may not be possible to issue a private mortgage security after January 2014 that meets the test for a “true sale” under US accounting rules. Thus we see the intense interest by the industry to change the provisions of Dodd-Frank, either through new legislation or a rule making procedure.  

One easy change would simply align the “qualified mortgage” rule from the Consumer Finance Protection Bureau with the narrower “qualified residential mortgage” rule to be set by the Fed and other regulators.  This does not "fix" the true sale issue, but provides issuers with enough comfort to do business in the agency markets.  But this still leaves the private mortgage market for RMBS outside the QM/QRM rules in legal limbo.  

By no accident, a very quiet discussion on the issue of true sale for securitizations has been underway for the past two years between the American Bar Association, the SEC and major audit firms. There may – emphasis may -- even be a statement released on the legal tests for true sales in coming weeks.  But the important thing for readers of ZH to understand is that the issue of “true sale” is settled law – except when it comes to Washington regulators and politicians.  

Going back to the landmark 1925 decision by Justice Louis Brandeis in Bendict v. Ratner, any transaction where the collateral is not specified is “fraud on its face.”  The sad thing is that we have Depression era securities laws in place today to deal with fraud of just the type seen in the 2007 subprime crisis, but the duplicitous cowards who populate Congress, the Fed, Treasury and Department of Justice refuse to act.  As regulators and members of Congress take another look at skin-in-the-game and Dodd-Frank, they ought to put the American Bar Association, SEC and other organizations on the record regarding “true sale.” Right now, the silence on the “true sale” issue is quite deafening.  

With all due respect to Chairman Bair and my friends at the FDIC, we need to think about lessening the economic “skin-in-the-game” for RMBS and focusing anew on enforcing US securities laws.  If we really want to fix the markets for private mortgage bonds and help the US economy grow, we need less skin-in-the-game in an economic sense and more federal prosecutions for securities fraud.  The FDIC has the institutional experience and legal responsibilities to lead this important conversation, but that agency has grown strangely silent since the departure of Chairman Bair.

Update 1:  Comment from one of my legal mentors.  Chris

"Really good article.  Two specific suggestions:  

(1) when a mortgagee transfers all material default risk to a party that identifies itself in the sale of securities transaction as accepting that risk (e.g., a private mortgage insurer) and the only interest retained by the mortgagee is "pure" servicing (only the obligation to make recoverable cash flow advances that have priority over the purchasers in foreclosure on individual properties and reps and warranties that are truly believed to be correct), "risk retention" should be waived, as it is for the GSEs (otherwise we are right back to the GSE monopoly problem) and

(2) get FDIC to recall that RTC showed the world how to disguise "full recourse" as reps and warranties--by saying everything done by originating S&Ls was perfect while knowing it was not)--in that case, reps and warranties are recognized as constituting recourse which creates secured debt, not a sale (See, Panteleo, et al, "Rethinking the Role of Recourse in the Sale of Financial Assets," 52 Bus. Lawyer 159)."