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.
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) 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.
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 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.
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 trading platforms. 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.
Policymaking initiatives should 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.
