In the paper, Credit Risk Transfer Governance: The Good, the Bad, and the Savvy, which was recently made publicly available on SSRN, I examine credit risk transfer (CRT) transactions and focus on credit default swaps (CDSs), collateralized debt obligations (CDOs), and other securitization transactions.
Governance research often focuses on the role of equityholders and directors at the institutional level. My paper, however, draws upon creditor governance scholarship and extends its insights to CRT at the transactional level. By examining CRT instruments such as CDSs and CDOs within the framework of creditor governance, it becomes possible to distinguish between good and bad CRT governance.
CRT governance consists of the transaction structures and practices that protect investors (and counterparties) against losses from the underlying credit risk being transferred. Good governance requires governance mechanisms to reduce the informational asymmetries and incentive misalignments of particular CRT transactions—the agency costs of CRT. Good CRT governance can protect investors (and counterparties) from losses even if the underlying assets whose credit risk is transferred experience significant losses. Bad CRT governance, by contrast, creates transaction structures that leave parties with highly sensitive exposures to losses in underlying credit assets. Savvy CRT transactions are those that produce gains for one side at the expense of the other because one side better understood how the governance of a particular CRT transaction should be priced, and positioned itself accordingly. Certain savvy hedge funds used synthetic CDOs to profit from the ultimate bursting of the housing bubble.
I argue that for unfunded CRT transactions such as CDSs, good governance can be achieved through counterparty governance mechanisms consisting of bilateral monitoring, collateralization, and a robust market infrastructure. Good governance for unfunded CRT does not require covenants, central clearinghouses, or swap execution facilities. Likewise, good governance for funded CRT transactions such as CDOs can be achieved through special purpose vehicle (SPV) governance mechanisms consisting of strong monitoring, substantial ex ante specification of creditors’ rights, performance-based covenants, and active SPV management. Good governance for funded CRT does not require a robust market infrastructure or risk retention by the issuer or manager.
In practice, most types of CRT transactions are well governed despite being subject to relatively little government regulation and oversight. This explains why the CDS market remained generally stable throughout the financial crisis and securitizations that transferred the credit risk of assets other than subprime residential mortgage-backed securities (RMBS), such as collateralized loan obligations and commercial mortgage-backed securities, performed relatively well and were not a source of systemic risk. Accordingly, this paper challenges much of the conventional and scholarly wisdom regarding CRT, which overemphasizes a lack of regulation as a primary cause of losses and systemic risk from CRT transactions. To the contrary, the financial crisis of 2008 is better understood as resulting primarily from the poor governance of cash CDOs and unfunded super senior tranches of synthetic CDOs whose prices failed to reflect that they were poorly governed yet nonetheless transferring massive credit risk from subprime RMBS.
Policymaking initiatives should thus narrowly target the uniquely bad governance of subprime residential mortgage-related CRT, but not the CDS or securitization markets more broadly. I conclude by identifying several implications of CRT governance for financial regulators implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
First, different CRT instruments can be substitutes for each other. Thus, to the extent policymakers increase the cost of one type of CRT instrument relative to another, parties may substitute accordingly and in a way that undermines regulatory goals. Second, because different governance mechanisms may be substitutes for each other, to the extent market participants resolve underlying governance problems, additional governance mandates may be redundant and unnecessarily costly. For example, as indicated by the structure of the first subprime RMBS since the financial crisis (the Springleaf Mortgage Loan Trust 2011-1), investors and ratings agencies are demanding better governance because they perceive subprime mortgages as being highly risky.
Third, there are likely important tradeoffs between regulatory goals such as transparency, liquidity, and standardization such that promoting one goal may come at the expense of others. For example, counterparty risk reducing CRT transactions such as contingent CDSs are insufficiently standardized to be centrally cleared or exchange traded. However, attempting to promote contract standardization generally by penalizing non-clearable trades with onerous capital requirements may decrease the willingness of parties to use contingent CDSs to reduce counterparty risk and thereby reduce the liquidity of contingent CDSs and their reference instruments. Finally, because credit risk cannot be eliminated once created but only reallocated, regulators should be cautious that mandates do not inadvertently concentrate risk. For example, CDS clearinghouses by definition concentrate counterparty risk and if not properly regulated and managed are likely to become a new class of “too big to fail” entities.
The full paper is available for download here.