Dugan Suggests Minimum Underwriting Standards, Instead Of Risk Retention

The American Securitization Forum's annual conference began Tuesday with a speech by the Comproller of the Currency, John Dugan. He began talking around 8:30, not but not exactly to a packed house. I estimated only 200 or so out of the over 4,000 total conference participants were present. Either they weren't much interested in hearing him speak, or the festivities last night carried on into the wee hours, and they couldn't make it out of bed that early. That's a shame, because it was a far more understanding and constructive speech than yesterday's by Assistant Secretary for Financial Institutions of the U.S. Treasury, Michael Barr. Dugan suggested that the popular "skin in the game" risk-retention proposal is misguided and offered an alternative.

He began by reviewing just how severely the financial crisis struck the securitization market. He noted that in 2009 securitization volume was about $1 trillion lower than three years prior. He sees the value that securitization can provide to the credit markets and believes the sector needs to be reformed and healed going forward.

He went through several of the major proposals on the table, but then focused on one that he found problematic. Like music to the conference participant's ears, he explained that he was uncomfortable with the "skin in the game" risk retention proposal. While he understands and agrees with the ultimate goal of the proposal, he has concerns. About the proposal he said:

But while lax underwriting is plainly a fundamental problem that needs to be addressed, mandatory risk retention for securitizers is an imprecise and indirect way to do that, and is by no means guaranteed to work. How much retained risk is enough? And what type of retained risk would work best - first loss, vertical slice, or some other kind of structure?

He said it's also "perverse" to require additional risk retention if new regulation already requires that securitizations are kept on-balance-sheet. He believes it would "materially reduce the amount of credit available for housing or any other sectors" that securitization serves. Instead, he suggests a better alternative for improving the quality of loans originated. Why not just allow regulators to directly establish minimum underwriting standards?

He names four basic, core standards:
- Effective verification of income and financial information
- Meaningful down payments
- Reasonable debt-to-income ratios
- For monthly payments that increase over time, qualifying borrowers based on the higher, later rate, rather than the lower, initial rate

Although he doesn't think this is the only reform necessary, he believes such minimum standards could be a better alternative to risk retention. He would also like to see better disclosures, credit rating reform and changes in compensation practices.

I'll be interested to gauge the reactions of the bankers present to this proposal. On one hand, they hate the "skin in the game" idea. On the other hand, minimum underwriting standards tie their hands in some ways. They could particularly hurt smaller banks that cater to specific niches or underserved segments of the population. Even though subprime borrowers broke the market over the past few years, subprime borrowing can be done effectively under certain circumstances.

But policymakers might find this suggestion an attractive way to streamline regulation. It has the flavor of a consumer financial protection agency, as it should prevent banks from writing loans that would harm consumers who are unable to pay. After all, that's not smart underwriting. But it would also accomplish the goal of banks adhering to sounder borrowing standards, without requiring them to retain some risk, which would necessarily curtail their loan volume and harm their capital position. I'm a little bit mixed on the proposal, for the reasons I explained, but it's certainly an idea worth thinking about.