Post by Sapphire Capital on Apr 22, 2009 10:12:56 GMT 4
Guilty by Association? Regulating Credit Default Swaps
Houman B. Shadab
George Mason University - Mercatus Center
Entrepreneurial Business Law Journal, Fall 2009
Abstract:
In response to what seems to be a need for greater regulation and oversight of credit default swaps (CDS), recently the Securities and Exchange Commission (SEC) promulgated exemptions and the House Agricultural Committee introduced a bill to have CDS cleared by a central counterparty. In addition, the SEC took action to facilitate the trading of CDS on an exchange and the House bill additionally seeks to enable the Commodity Futures Trading Commission (CFTC) to suspend trading in CDS to prevent the manipulation of certain public company bond prices. The policymakers' stated motivations echoed widely expressed criticisms of the regulation, characteristics, and practices of the CDS market, and focused on the risks of the instruments and the lack of public transparency over their utilization and execution. Certainly, CDS enabled mortgage-backed security risk to be overconcentrated in some financial institutions.
Yet as the analysis in this Article suggests, failing to distinguish between CDS derivatives and the actual mortgage-related debt securities, entities, and practices at the root of the financial crisis may hold CDS guilty by association. Although the financial instruments share some superficial similarities, structured debt securities are very different from CDS and underwriters of such securities make financial decisions under a very different legal and economic framework than those made by CDS dealers. Unmanageable losses from CDS exposures were largely symptomatic of underlying deficiencies in mortgage-related structured finance and do not primarily reflect fundamental weaknesses in the risk management and infrastructure of the CDS market. In addition, the development of CDS referencing mortgage-related securities seems to have been more of an effect than a cause of the rapid growth in mortgage-related securitization.
The SEC's exemptions to facilitate the central clearing and exchange trading of CDS seem desirable, although a significant portion of CDS transactions are unlikely to be improved by utilizing such venues. However, the House bill mandating central clearing is likely unnecessary to reduce CDS counterparty risk and may, in fact, increase counterparty risk to the extent a CDS clearinghouse undermines bilateral risk management. Counterparty risk management has generally been prudent in the CDS market and the role of CDS in facilitating price discovery also calls into question the desirability of enabling the CFTC to suspend trading in certain CDS, even under very limited circumstances.
Policymakers should act to prevent the concentration of CDS risk at the institutional level -- particularly when sold by insurance companies, purchased by banking institutions for their debt portfolios, or likewise utilized by their unregulated subsidiaries. Reform of CDS transactions at the instrument level does not seem warranted, however. AIG's excessive risk taking with a portion of its CDS portfolio was part of a more fundamental companywide practice and reflected the even broader economywide problem of seeking returns from mispriced mortgage-backed securities. Over-the-counter derivatives markets are in important ways superior to securitization in effecting risk transfer and thereby provide insights as to the most efficient and stable market microstructure for such purposes and the direction towards which financial modernization should take place.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1375612_code790790.pdf?abstractid=1368026&mirid=2
Houman B. Shadab
George Mason University - Mercatus Center
Entrepreneurial Business Law Journal, Fall 2009
Abstract:
In response to what seems to be a need for greater regulation and oversight of credit default swaps (CDS), recently the Securities and Exchange Commission (SEC) promulgated exemptions and the House Agricultural Committee introduced a bill to have CDS cleared by a central counterparty. In addition, the SEC took action to facilitate the trading of CDS on an exchange and the House bill additionally seeks to enable the Commodity Futures Trading Commission (CFTC) to suspend trading in CDS to prevent the manipulation of certain public company bond prices. The policymakers' stated motivations echoed widely expressed criticisms of the regulation, characteristics, and practices of the CDS market, and focused on the risks of the instruments and the lack of public transparency over their utilization and execution. Certainly, CDS enabled mortgage-backed security risk to be overconcentrated in some financial institutions.
Yet as the analysis in this Article suggests, failing to distinguish between CDS derivatives and the actual mortgage-related debt securities, entities, and practices at the root of the financial crisis may hold CDS guilty by association. Although the financial instruments share some superficial similarities, structured debt securities are very different from CDS and underwriters of such securities make financial decisions under a very different legal and economic framework than those made by CDS dealers. Unmanageable losses from CDS exposures were largely symptomatic of underlying deficiencies in mortgage-related structured finance and do not primarily reflect fundamental weaknesses in the risk management and infrastructure of the CDS market. In addition, the development of CDS referencing mortgage-related securities seems to have been more of an effect than a cause of the rapid growth in mortgage-related securitization.
The SEC's exemptions to facilitate the central clearing and exchange trading of CDS seem desirable, although a significant portion of CDS transactions are unlikely to be improved by utilizing such venues. However, the House bill mandating central clearing is likely unnecessary to reduce CDS counterparty risk and may, in fact, increase counterparty risk to the extent a CDS clearinghouse undermines bilateral risk management. Counterparty risk management has generally been prudent in the CDS market and the role of CDS in facilitating price discovery also calls into question the desirability of enabling the CFTC to suspend trading in certain CDS, even under very limited circumstances.
Policymakers should act to prevent the concentration of CDS risk at the institutional level -- particularly when sold by insurance companies, purchased by banking institutions for their debt portfolios, or likewise utilized by their unregulated subsidiaries. Reform of CDS transactions at the instrument level does not seem warranted, however. AIG's excessive risk taking with a portion of its CDS portfolio was part of a more fundamental companywide practice and reflected the even broader economywide problem of seeking returns from mispriced mortgage-backed securities. Over-the-counter derivatives markets are in important ways superior to securitization in effecting risk transfer and thereby provide insights as to the most efficient and stable market microstructure for such purposes and the direction towards which financial modernization should take place.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1375612_code790790.pdf?abstractid=1368026&mirid=2