Tim Fernholz at The American Prospect argues that Paul Krugman and I are misunderstanding the intention of the "skin in the game" aspect of Obama's financial regulatory overhaul plan:

"It's not intended, as Jelveh and Krugman propose, to keep big banks from selling away risk. It's targeted at mortgage originators, and in fact already came up in Barney Frank's anti-predatory mortgage lending legislation earlier in the year."

Here is the relevant language from the Treasury's white paper: (page 45

One of the most significant problems in the securitization markets was the lack of sufficient incentives for lenders and securitizers to consider the performance of the underlying loans after asset backed securities (ABS) were issued...The federal banking agencies should promulgate regulations that require loan originators or sponsors to retain five percent of the credit risk of securitized exposures.

That reads to me that both orginators and securitizers are being targeted. (Investment banks, for example, were not shy about sponsoring.) 

But if indeed the legislation is largery targeted at independent mortgage brokers and lenders, then it'll surely have very little effect in preventing another crisis.

There are at least a couple of reasons for this: First, as I mentioned on Tuesday, the largely unregulated independents actually originated better performing loans than the big banks. (Here is the paper I'm citing again, which was written by Benjamin J. Keys of U. of Michigan, Tanmoy K. Mukherjee of Sorin Capital Management, Amit Seru of the U. of Chicago, and Vikrant Vig of the London Business School.) 

And second, the epicenter of global economic crisis was the big banks -- not the independents. If we lived in a world were Lehman, Citi, BofA, etc. were not exposed to subprime risk, the current economic picture would likely be quite different. Sure, the mortgage industry would've taken a huge hit, but the recession would be more localized around the real estate industry and look less like the Great Depression and more like the tech bust.

That isn't to say that the independents should remain un-policed, but that the role they played in the lending and securitization process wasn't the central cause of the crisis. As I tried to point out yesterday, along with the aid of a couple of commenters, in order to decrease the chance of another subprime-type crisis, future systemic risk regulators should police the use of securitization and off-balance-sheet SPVs used by the big banks to hide increased leverage

So, if the intention of the proposed legislation is to prevent another mortgage securitization-related crisis, targeting the independents isn't the answer. Figuring out who should be allowed to securitize, building products that aren't so sensitive to home prices, and/or preventing regulatory arbitrage are the issues that need addressing, which hopefully will be the case later this year.

--Zubin Jelveh