The Risk Retention Rule emerged after the 2008 financial crisis to address the risky lending that led to massive losses in mortgage-backed securities. Before the rule, lenders could originate loans and quickly sell them off, passing all credit risk to investors. This disconnect encouraged the issuance of risky loans, contributing to the financial system’s instability.
Under the rule, financial institutions bundling loans like mortgages, auto loans, or credit card debt into asset-backed securities must retain a minimum 5% credit risk stake, often referred to as “skin in the game.” By holding this portion, securitizers have a direct financial interest in the credit quality of the loans.
There are three main methods for retaining this risk:
- Vertical Slice: Retaining 5% of each tranche of the security, providing exposure across all loan classes.
- Horizontal Slice: Holding the most subordinate 5% of the structure, absorbing first losses if loans default.
- Hybrid Approach: A combination of vertical and horizontal retention.
The rule includes exemptions, most notably for securities backed entirely by Qualified Residential Mortgages (QRMs). QRMs meet strict credit quality standards, such as verified income, solid credit history, reasonable debt-to-income ratios, and adequate down payments. This exemption incentivizes safer lending practices.
Borrowers benefit from the Risk Retention Rule because it encourages lenders to issue higher-quality loans, improving overall lending standards. Investors gain extra protection, knowing securitizers share in potential losses. Ultimately, the rule contributes to a more stable financial system.
Enforced by multiple agencies including the Securities and Exchange Commission (SEC), Federal Reserve, and Federal Deposit Insurance Corporation (FDIC), the rule balances the need to protect investors with ensuring access to credit.
For more on Qualified Residential Mortgages (QRM), visit our detailed glossary article.
