Friday, November 12, 2010

Qualified Residential Mortgages and Structured Finance

In the wake of the credit crisis and the hundreds of billions of dollars of losses on structure finance securities, particularly residential mortgage-backed securities, global legislation has featured the idea of making issuers of these securities retain skin in the game.  The logic behind the retention requirement is that having skin in the game gives the issuer an incentive to do a better job underwriting the loans backing the structured finance security.

Whether this logic is accurate or not is a topic for a different blog entry (hint:  look at the losses the financial institutions suffered on their retained book of business).

What is true though is that skin in the game is complementary to and not a substitute for investors knowing what they own.  As discussed in earlier posts using the Brown Paper Bag Challenge, for investors to have the information that they need 'when' they need it to make a buy, sell or hold decision on an individual structured finance security requires that they are provided with observable event based reporting on the underlying collateral performance.

If a mortgage does not provide observable event based reporting to investors when it is included in a structured finance security, no mortgage should be considered a qualified residential mortgage.

Under the Dodd-Frank Act, regulators have been given the responsibility of defining what is a qualified residential mortgage.  Qualified residential mortgages are exempt from the Dodd-Frank issuer retention requirements when packaged into structured finance securities.

The Wall Street Journal featured an article that describes how both investors and issuers would like the regulators to define qualified residential mortgages.

Investors favor a limited definition of a qualified residential mortgage.  These mortgages would have high down payments, say 20%, and fixed interest rate payments.

Issuers favor a broad definition of a qualified residential mortgage.  These mortgages would have lower down payments and private mortgage insurance.  They could have fixed or variable rates including teaser rates.

However the regulators decide, just because a certain type of mortgage did not perform poorly in the past is no guarantee that it will not perform poorly in the future.  As a result, regulators must require that for a mortgage to qualify as a qualified residential mortgage, it must provide investors with observable event based reporting on its performance when packaged in a structured finance security.

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