Skin in the Game
I can’t stand it. We now have skin in the game provisions proposed by the SEC, the FDIC, the House of Representatives and the United States Senate.
On CNN the other day, Congressman Barney Frank said that the most important part of the House Financial Reform bill was skin in the game in securitization. Okay, I know we’re probably stuck with it and the world will not end. Capital formation will be modestly depressed and the geniuses on the Street will work overtime to mitigate the impact of all that excess capital sloshing around. But it pains me to give up the fight. Skin in the game is certainly an attractive slogan and, superficially, it makes a great deal of sense. But no one has really looked at the data. The worst performing sector in the fixed income world was, without doubt, loans to developers, builders and the like. All of this lending activity was on book or, in the skin in the game parlance; the lenders had nothing but skin in the game.
Hello! Lehman failed. Bear failed. Merrill failed (more or less). The GSEs don’t even bear thinking about. All of this carnage happened not because the institutions were brilliantly successful in laying off bad credit to dumb investors, but because they had skin in the game. In the CMBS sector, mortgage loan originators generally sold 100% of the risk of the loans they originated, and the sector is experiencing losses generally consistent or somewhat better than the performance of commercial real estate taken as a whole. Again, explain to me how skin in the game is going to fix this?
Moreover, all of the legislative and regulatory proposals also go out of the way to demand the lenders do not hedge the skin. Huh? Didn’t we just finish castigating the banking sector for mismanaging risk? So now we’re giving notice that such negligence is obligatory? I don’t get it.
The fascination with skin amounts to misdirection. It sucks the air out of a debate on other steps which could get at the real problem. Let’s think about underwriting standards, for goodness sakes.
The SEC, in its recent request for comment to its proposed ABS rule asked for input on whether the structure of CMBS, with a hard-nosed B-piece buyer at the bottom of the capital stack, is a good way to achieve the benefits promised by skin in the game. Maybe the final regulations will embrace that view. That would represent adult leadership. But, the political wisemen tell me, no chance, we’re stuck with skin in the game. Another great idea brought to us through the bounty of the populist sound byte.
There is no data on how effective skin in the game will be. However, common sense dictates that if I own a piece of my creation forever I will make sure my creation lasts a long time. In CMBS we know how b-piece buyers shed their skins like a snake. I am troubled by congress allowing b-piece buyer holding a piece rather than the originators.
No one cared ones they made their yield-to-bonus. Time will tell if this will work.
Many issuers have indicated retention is not an issue anymore. Perhaps they have realized they can't possibly get away from it. Greed is good. Issuance will not stall for retention reasons.
But then, we all know it is a matter of time before banks find a way to get around these hurdles. There is still creativity on wall street.
Skin in the game is neither a bad idea nor a panacea. I agree, there is little data. It's also true that, if I break it I own it, makes one careful. Anecdotally, however, the worst performing sectors of the commercial real estate space have been the builder book and construction loans. That is, by God, 100% skin in the game stuff!
The CMBS B buyer was a stern manager of risk until the CRE CDO business was invented. That, indeed, sucked discipline out of the equation. But that business has gone and will be gone for so long, we might as well say gone for good. The return of the aggressive B buyer in 2010 (who often kicked out as many as 30% of the loans in a pool) will restore discipline. All said, skin in the game is not a game changer.
Finally, while we're at it, let's be mindful that the anti-hedging provisions in all of the various iterations of our fascination with skin are grossly inconsistent with the still important goals of safety and soundness in our banking community. But what's a few stray unintended consequences.