Skin-in-the-Game: Risk Retention Lessons from Credit Card Securitization
Adam J. Levitin
Georgetown University Law Center
May 1, 2013
George Washington Law Review, Vol. 81, No. 3, pp. 813-855 (2013)
Georgetown Law and Economics Research Paper No. 11-18
Georgetown Public Law Research Paper No. 11-116
The Dodd-Frank Act’s “skin-in-the-game” credit risk retention require- ment is the major reform of the securitization market following the housing bubble. Skin-in-the-game mandates that securitizers retain a 5% interest in their securitizations. The premise behind skin-in-the-game is that it will lessen the moral hazard problem endemic to securitization, in which loan originators and securitizers do not bear the risk on the ultimate performance of the loans. Contractual skin-in-the-game requirements have long existed in credit card securitizations. Their impact, however, has not been previously examined.
This Article argues that credit card securitization solves the moral hazard problem not through the limited risk retention of formal skin-in-the-game re- quirements, but through implicit recourse to the issuer’s balance sheet. Absent this implicit recourse, skin-in-the-game actually creates an incentive misalign- ment between card issuers and investors because card issuers have lopsided upside and downside exposure on their securitized card receivables. For- mally, the card issuers bear a small fraction of the downside exposure, but retain 100% of the upside, should the card balance generate more income than is necessary to pay the investors. The risk/reward imbalance should create a distinct problem because the card issuer retains control over the terms of the credit card accounts. Prior to the Credit CARD Act of 2009, the issuer could increase a portfolio’s volatility through rate-jacking: when interest rates and fees are increased, some accounts will pay more and some will default. Per the Black-Scholes option-pricing model, the increased volatility benefits the issuer because of the risk-reward imbalance.
Despite the problems posed by the formal risk/reward imbalance, credit card securitization avoided the excesses of mortgage securitization. The ex- planation for this is that credit card securitization features complete implicit recourse. Implicit recourse exists because credit card securitization is not about risk transfer, but instead is about regulatory capital arbitrage and creat- ing a funding and liquidity source for the issuer. The implication is that for- mal skin-in-the-game requirements alone may be insufficient to ensure against moral hazard problems in securitization. Skin-in-the-game’s effectiveness will instead depend on its interaction with other deal features.
Number of Pages in PDF File: 43
Keywords: securitization, risk retention, skin-in-the-game, credit cards, excess spread, tranching, information asymmetry, moral hazard, Black-Scholes, option pricing, implicit recourse, rate-jacking, Credit CARD Act
Date posted: August 9, 2011 ; Last revised: March 4, 2014