Mark Calabria

One of the more controversial provisions of the Dodd-Frank Act is Section 941. This section requires an issuer of an asset-backed security to retain “not less than 5% of the credit risk.” Section 941 was intended to address the collapse in the residential mortgage backed securities market following the subprime meltdown, but it covers other securitization asset classes as well. The theory behind risk retention is that having “skin in the game” will better align the incentives of issuers and investors, ultimately improving the quality of securitized assets. Setting aside whether such a theory has any relation to the recent financial crisis — after all Fannie Mae and Freddie Mac retained 100% of the credit risk on their MBS and that didn’t turn out so well — the residential mortgage market rightly has attracted a unique focus in regulatory reform efforts.

The Dodd-Frank Act requires no less than 49 separate rulemakings in the area of mortgage finance, according to the law firm Davis Polk. While disagreeing on the causes, commentators across the political spectrum assign a special role to residential mortgages in the recent crisis. Few, if any, assign a role to collateralized loan obligations. CLOs are actively managed funds that invest in senior, secured commercial loans to American businesses. Compared to most asset classes, CLOs performed well during the financial crisis, even if new issuance fell for a short time following the crisis. The cumulative impairment rate — losses experienced over the life of the asset — for CLOs over the last 17 years has been less than 1.5%, according to Moody’s. That is trivial. Section 941 provides regulators sufficient discretion to protect investors while leaving the market for collateralized loan obligations largely intact. They should do so.

Given the political environment, the regulators appear to have read the statute very broadly and applied Section 941 to CLOs. What is explicit in Section 941 is that regulators may adopt exemptions or exceptions to the risk retention requirements. The most obvious route would be to define a category of high quality CLO that would be exempt from risk retention. Such has been done for other asset classes. In at least one case, that of residential mortgages, a significant portion of the overall market was exempted. If such can be done for residential mortgages, then a comparable approach to CLOs would appear more than reasonable.

Mark Calabria

Mark A. Calabria, is director of financial regulation studies at the Cato Institute.