What are the risk retention rules for securitizations, and why do they require 'skin in the game'?

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AcadiFi · Accepted Answer

Risk retention rules were among the most important regulatory responses to the 2008 crisis. The core problem was that originators had no incentive to maintain underwriting standards if they could sell 100% of the risk to investors through securitization.

## The Moral Hazard Problem

Pre-crisis, the originate-to-distribute model worked as follows:
1. Lender originates mortgages (or other loans)
2. Lender packages them into a securitization vehicle (SPV)
3. SPV issues tranches to investors
4. Lender pockets origination fees and walks away with zero residual risk

**Result:** No skin in the game means no incentive to screen borrowers carefully. Underwriting standards collapsed.

## The 5% Retention Rule

Post-crisis regulations (Dodd-Frank in the US, CRR in Europe) require the originator, sponsor, or original lender to retain at least **5% of the credit risk** of the securitization.

## Forms of Retention

The 5% can be held in several ways:

| Retention Form | Description |
|---|---|
| **Vertical slice** | Retain 5% of each tranche issued (proportional exposure) |
| **Horizontal slice (first loss)** | Retain the equity tranche equal to 5% of total issuance |
| **L-shaped** | Combination of vertical and horizontal |
| **Random selection** | Retain a random 5% of the underlying exposures (on-balance-sheet) |
| **Originator share** | Originator retains 5% of each originated exposure before securitizing |

## Example

Vantage Mortgage Corp securitizes a $500M pool of residential mortgages into the following structure:

| Tranche | Size | Rating |
|---|---|---|
| Senior | $400M | AAA |
| Mezzanine | $60M | BBB |
| Equity | $40M | Unrated |

Under the **horizontal (first loss)** approach:
Required retention = 5% x $500M = $25M
Vantage must retain at least $25M of the equity tranche.

Under the **vertical slice** approach:
Vantage retains 5% of every tranche:
- 5% x $400M = $20M of Senior
- 5% x $60M = $3M of Mezzanine
- 5% x $40M = $2M of Equity
- Total = $25M

```mermaid
flowchart TD
    POOL["$500M Loan Pool"] --> SPV["Securitization Vehicle"]
    SPV --> SEN["Senior $400M AAA"]
    SPV --> MEZ["Mezzanine $60M BBB"]
    SPV --> EQ["Equity $40M NR"]
    subgraph Retained["5% Retention Options"]
        VERT["Vertical: 5% of each tranche"]
        HORIZ["Horizontal: First-loss piece >= 5%"]
    end
    SPV -.->|"Originator keeps
skin in the game"| Retained
```

## Basel Treatment

Under Basel III/IV, investors in securitizations face higher capital charges if:
- The originator has NOT met the retention requirement
- The securitization is a "re-securitization" (CDO-squared)
- The investor cannot demonstrate due diligence on the underlying pool

## Why Horizontal Is Strongest

The equity (first-loss) tranche absorbs the first dollars of loss. If the originator holds this piece, they are directly exposed to poor underwriting — creating the strongest alignment of incentives. This is why regulators generally prefer horizontal retention.

For more on securitization regulation, check our FRM Part II course.

What are the risk retention rules for securitizations, and why do they require 'skin in the game'?

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