It all seemed so simple. The cause of the financial crisis was that private label securitizers of subprime mortgage loans weren't required to "have enough skin in the game," so Dodd-Frank would require them to retain 5% of the risk.

That requirement would be too stiff for traditional mortgages, e.g. those with a 20% down-payment, so an exemption would be provided for "qualifying residential mortgages. But the down-payment language was dropped from the QRM definition before the bill was finalized, and a political debate has raged since the bill became law over the appropriate definition of a QRM as well as what 5% risk-retention really means (hint: it depends on what the definition of "is" is).

That politics would undermine this regulatory approach before regulations were ever promulgated was inevitable because the premise underlying Dodd-Frank is false. It wasn't the lack of risk-retention regulations that produced the astronomical leverage — the lack of "skin in the game," a colorful way of saying capital at risk — that enticed sub-prime lending, but the substitution of such regulations for investor judgment and market discipline.

It took decades for these regulations to be politically manipulated to the ridiculously low levels characterizing the subprime lending debacle, with Dodd and Frank being two of the biggest manipulators. By embedding new, modest but ill-defined one-size-fits-all requirements in legislation, the Dodd-Frank Act further politicized the determination of risk retention requirements.

Third party investors in mortgages had historically determined how much "skin in the game" was necessary for borrowers and lenders. Underwriting played some role, but a 20% down payment or private mortgage insurance was a time-tested borrower requirement. Lenders were generally required to participate in losses, usually bearing the first loss.

The Ginnie Mae pass-through security deviated in several respects from this model. First, it substituted government-sponsored (FHA) for private mortgage insurance. Second, originators had skin in the game in two ways: Ginnie Mae required an "excess servicing spread" that shifted part of the cost of default to the originator-servicer, and required "cross collateralization" of all servicing contracts so that a default on one resulted in a Ginnie Mae seizure of all. Fannie Mae and Freddie Mac conventional loan purchases were limited to loans with 20% down or private mortgage insurance and a corporate capital requirement appropriate for a mortgage "pool" insurer of insured loans. These safeguards worked for decades.

The REMIC legislation passed in 1986 essentially removed the obstacle for private label securitizers of taxing all cash flows at the pool level before distributions to investors, putting them on par with Ginnie, Fannie and Freddie in respect to this aspect of the federal income tax. As was historically the case in the private secondary market, the distribution of risks among the borrower, lender and investor was left up to the market to decide.

But regulators rather than markets determined capital retention requirements for publically insured banks and thrifts, creating huge potential profits from "regulatory arbitrage." Unlike mortgage-backed bonds, a type of "financing" for mortgage originators including banks and thrifts, private label securities followed the GSE approach of treating these securitizations as a "sale of assets" rather than a financing.

The first and most obvious regulatory arbitrage was that banks and thrifts could securitize, treat the assets as "sold" for regulatory capital purposes, and then finance any residual retained interests with the same leverage allowed by regulation for investments generally. This loophole was eventually plugged, but regulators couldn't possibly keep up with too-big-to-fail bank and Wall Street arbitrageurs.

The regulatory arbitrage opportunities available to private label securitizers paled in comparison to those available to the GSEs, leaving them with the "crème-de-la-crap" of subprime mortgages.

Nevertheless, Fannie and Freddie responded during the first half of the last decade to protect market share by weakening both underwriting and, more importantly, down-payment and private mortgage insurance requirements. Their "risk retention," i.e. capital requirements, should have been raised dramatically in response, but politicians mandated the opposite, facilitating leverage of as much as 200 to 1 for GSE securitizations of un-insured risky sub-prime mortgage loans.

Fortuitously for private label securitizers, the SEC substituted regulatory for investor risk retention requirements for their securities as well, allowing them to compete with the GSEs by financing somewhat riskier mortgages with somewhat less leverage.

The designation of Nationally Recognized Statistical Ratings Organizations, i.e., credit rating agencies — substituted ratings for investor due diligence when investing in "investment grade" securities, and risk-based capital rules set the capital requirements for depository institution investments based on these ratings, regardless of the risk retained by originators. Moreover, TBTF commercial banks could leverage these investments even more, about 100 to 1, by financing them in a "sponsored" off-balance sheet structured investment vehicle. This shifted the determination of the amount of risk retained by originators (or their sponsored hedge funds) to the ratings agencies.

Whereas by 2004 deposit institutions had to fund the retained risk entirely with capital, the 2004 SEC designation of "consolidated supervised entities" allowed private label originating investment banks to leverage these retained interests at about 30 to 1, with much of this leverage financed by bank repos and money market fund commercial paper purchases. And the profits from securitization — recognition of which could be accelerated under SEC accounting rules — generally exceeded the value of the retained interests, so securitizers came out ahead even when the loans subsequently defaulted.

In the sea of political supplicants who are lobbying the QRM and risk retention issues to determine how much "skin" is required, the question is "Where's Waldo,", i.e. the at-risk investor? Waldo is there, fully obscured by Dodd-Frank and hiding behind the excessive regulation that politicians claim was missing during the subprime debacle. When the time comes, at-risk investors will refuse to accept the political risk inherent in the new rules, so expect the administration — with the support of investors — to announce that private markets have "failed" to recover, and that it is time to move on with a "reformed" GSE approach.

Kevin Villani is a former senior vice president and chief economist at Freddie Mac.