2011 Illinois Corporate Colloquium: Shadab on credit risk transfer

Larry Ribstein —  8 September 2011

The 2011 Illinois Corporate Colloquium got off to a good start with Houman Shadab presenting his paper, The Good, the Bad, and the Savvy: Credit Risk Transfer Governance.  Here’s the abstract:

Goldman Sachs and AIG on the eve of the 2008 financial crisis were bound together through a web of credit risk transfer (CRT) contracts in the form of credit default swaps (CDSs) and synthetic collateralized debt obligations (CDOs). Synthetic CDOs enabled hedge funds to profit from the ultimate bursting of the housing bubble due to the funds’ savvy in understanding CRT better than their counterparties. This Article constructs a novel theory of CRT that extends the insights of creditor governance theory to CRT transactions. Creditor governance theory has thus far has been primarily limited to analyzing loans and bonds and not CRT instruments.

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 instruments. 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 even without the use of 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 even with a weak market infrastructure and without 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 Article 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 best understood as resulting from poor CRT governance. The only transactions underlying the financial crisis were 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 in the form of 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. This Article concludes by identifying several implications of CRT governance for financial regulators implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. An important implication of CRT governance is that additional regulation may increase the risk of CRT transactions.

The paper’s main contribution is to extend the “creditor governance” literature to the alphabet soup of credit risk transfer instruments. Well-governed instruments benefit society, poorly governed instruments don’t. The “savvy,” including the likes of John Paulson, can make money from correctly recognizing risks ahead of the rest of the market.

This approach somewhat simplifies analysis of the financial crash by reducing it to a governance problem.  But as we discussed in the Colloquium, this raises another question:  why were RMBS’s poorly governed while collateralized loan obligations and commercial mortgage-backed securities were not?  More precisely, why did the market effectively discipline some types of instruments and not others?  We need to answer this question to effectively regulate future transactions.

The obvious answer would seem to be that the market was able to price some risks better than others.  But why is that?

Houman suggests that the reason may be that the real risk in RMBS’s was in a second tier of securities that were hidden from investors’ immediate view.  I was skeptical of that explanation for two reasons.  First, since investors knew about the existence of the second level, it would seem their ignorance would be priced.

A second reason for skepticism is Bobby Bartlett’s presentation to last year’s colloquium:  Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures During the Financial Crisis.  Bartlett shows that the market did not appropriately discount disclosed risks of RMBS’s. He concludes by noting:

Reform efforts aimed at enhancing derivative disclosures should accordingly focus on mechanisms to promote the rapid collection and compilation of disclosed information as well as the psychological processes by which information obtains salience.

What specific reform efforts might we consider?  When I concluded the discussion with that question, Houman responded that investors may have over-relied on the credit rating services.  This suggests we should eliminate the official status of credit ratings in financial regulation — something that Dodd-Frank did.  It will be interesting to test whether this has the desired effect.

So maybe Dodd-Frank did do some good.  Of course it also did a lot of other things.

In all, an interesting and timely discussion in the tradition of the CoIloquium to present theoretical perspectives on corporate governance that are both engaging for faculty and useful for students. (And, yes, I think this combination is possible).   I’m looking forward to more great talks this semester, as in prior semesters (see the Colloquium link above for speaker lists).  I hope to get time to blog on most of them.

Update:  Houman’s blog, “Lawbitrage,” notes that the RMBS market apparently has learned from the past.  This reminds us that even if markets don’t always operate perfectly, they at least have the capacity to adjust to mistakes.  Compare government.

Larry Ribstein

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Professor of Law, University of Illinois College of Law