Guilty by Association? Regulating Credit Default Swaps

A wide range of U.S. policymakers initiated a series of actions in 2008 and 2009 to bring greater regulation and oversight to credit default swaps (CDSs) and other over-the-counter derivatives. 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, the misuse of certain CDSs enabled mortgage-related security risk to become 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 CDSs guilty by association. Although structured debt securities and CDSs share some similarities and were often utilized together in synthetic securitizations, the financial instruments are highly distinct and underwriters of such securities make 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 CDSs referencing mortgage-related securities was more of an effect than a cause of the rapid growth in mortgage-related securitization. Exemptions by the Securities and Exchange Commission to facilitate the central clearing and exchange trading of CDSs seem desirable, although a significant portion of CDS transactions are unlikely to be improved by utilizing such venues. However, mandatory central clearing is likely unnecessary to reduce CDS counterparty risk and may, in fact, increase counterparty risk to the extent CDS clearinghouses unduly concentrate risk or undermine bilateral risk management. Counterparty risk management in the CDS market has generally been prudent, and systemically troubling CDS transactions arose only from a small portion of the market where financial guarantors sold CDS protection to banks on their mortgage-related debt securities. The role of CDSs in facilitating price discovery also suggests that prohibiting uncovered (naked) CDSs to prevent speculation will decrease transparency in the credit markets. The systemically troublesome CDSs sold by AIG and certain bond insurers were purchased by banks on their mortgage-related securities and not for speculation. Ongoing reforms being undertaken by CDS market participants under the supervision of the Federal Reserve Bank of New York to achieve greater transparency and stability call into question the extent to which additional regulation is necessary. Policymakers should act to prevent the concentration of CDS risk in regulated institutions, particularly when CDSs are sold by insurance companies, purchased by banking institutions, or likewise utilized by such institutions’ unregulated subsidiaries. However, increasing regulation of all CDS transactions or all users of CDSs does not seem warranted

Counterparty Regulation and Its Limits: The Evolution of the Credit Default Swaps Market

Over-the-counter (OTC) derivatives are widely regarded as “unregulated” financial instruments. While it is true that OTC derivatives are subject to relatively minimal federal regulation, OTC derivatives are in fact subject to a robust form of control and governance in the form of counterparty regulation. Counterparty regulation arises when two or more parties are continually exposed to counterparty credit risk for the duration of a long-term contract, and it consists of specific governance mechanisms such as the daily adjustment of collateral and the netting out of redundant trades. Counterparty regulation governs derivatives transactions but not securities transactions. This essay reviews recent significant developments in the market for one type of OTC derivatives contract in particular - the market for credit default swaps (CDSs) - and suggests that these developments illustrate the strengths and limitations of counterparty regulation. Given the overall strength of CDS counterparty regulation during the financial crisis, and cooperative efforts being undertaken by CDS market participants and regulators to improve CDS market infrastructure, comprehensive federal regulation of CDSs does not seem necessary to achieve greater transparency and financial stability

Credit Risk Transfer Governance: The Good, the Bad, and the Savvy

Goldman Sachs and American International Group 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 certain 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. By doing so, this Article establishes a framework for good CRT governance. CRT governance consists of the transaction structures and practices adopted to protect investors (or 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. In practice, most types of CRT transactions are generally well governed and do not contribute to systemic riskdespite being lightly regulated. Accordingly, it is incorrect to view the destabilizing losses from subprime residential mortgage-related CRT in 2008 as an inevitable result of CRT transactions being insufficiently regulated or fundamentally flawed. The financial crisis is best understood as resulting from the uniquely poor governance of certain cash CDOs and super senior tranches of synthetic CDOs. This Article concludes by identifying several implications of CRT governance for financial regulators implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act

The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection

A persistent theme underlying contemporary debates about financial regulation is how to protect investors from the growing complexity of financial markets, new risks, and other changes brought about by financial innovation. Increasingly relevant to this debate are the leading innovators of complex investment strategies known as hedge funds. A hedge fund is a private investment company that is not subject to the full range of restrictions on investment activities and disclosure obligations imposed by the federal securities laws, that compensates management in part with a fee based on annual profits, and typically engages in the active trading of financial instruments. Hedge funds engage in financial innovation by pursuing novel investment strategies that lower market risk (beta) and may increase returns attributable to manager skill (alpha). Despite the funds’ unique costs and risk properties, their historical performance suggests that the ultimate result of hedge fund innovation is to help investors reduce economic losses during market downturns. In 2008, as losses from the U.S. subprime mortgage market transformed into an international financial crisis, the value of global equities dropped 42 percent while hedge funds worldwide lost a comparatively smaller 19 percent for their investors. By increasing investors’ ability to maximize risk-adjusted returns, hedge funds advance the same goal that federal investor protection regulation seeks to advance. This Article argues that the beneficial outcomes hedge funds attain for their investors are largely attributable to the legal regime under which they operate. The hedge fund legal regime includes not only federal securities law but also the entity and contract law provisions governing the fund, its manager, and its investors. Federal law applicable to hedge funds enables the funds to pursue innovative investment strategies employing the trifecta of leverage, short sales, and derivatives. The entity and contract law governance of hedge funds provides high-powered incentives for fund managers to engage in and capture the gains from financial innovation.A general lesson from the law and economics of hedge funds is that when a legal regime permits financial intermediaries to be flexible in their investment strategies and aligns the incentives of investors and innovators through performance fees and co-investment by managers, financial innovation is likely to complement investor protection without wide-ranging regulation. The role of hedge funds in advancing the same goal as investor protection regulation suggests that they should legally be available to a broader class of investors

The financial crisis\u27 unintended consequence

This post originally appeared on https://thehill.com/opinion/op-ed/92685-the-financial-crisis-unintended-consequenc

Henry Manne and Nonpublic Company Disclosure

This essay discusses Henry Manne\u27s 1974 article, Economic Aspects of Required Disclosure Under Federal Securities Law,\u27 and its application to nonpublic disclosure regimes such as that applicable to hedge funds and startups crowdfunding capital under the Jumpstart Our Business Startups Act of 2012

Fending for Themselves: Creating a U.S. Hedge Fund Market for Retail Investors

1 mapa. A la part superior: Pl. XII

Hedge Fund Governance

This Article provides the first comprehensive scholarly analysis of the internal governance of hedge funds. Hedge fund governance consists of the funds\u27 underlying legal regime and the practices they adopt in response to lacking permanent capital and to reduce agency costs. Hedge fund governance is important because better governance can improve investor returns and help managers raise and retain capital. I argue that hedge fund governance is best understood as a type of responsive managerialism. It is a type of managerialism because applicable law and contracting structures give managers uniquely wide-ranging control over the fund and its operations. Hedge fund governance is also uniquely responsive, however, because managers must continually satisfy investors, due to their ability to shut down a fund by withdrawing their capital. In addition to their underlying legal regime, the primary components of hedge fund governance are investors with a strong propensity to exercise their short term redemption rights, managers with high pay-performance sensitivity, investor demand for quality governance, and close monitoring by short-term creditors and derivatives counterparties. On balance, hedge fund governance devices seem to prevent managers from pursuing their own interests at the expense of investors. Nonetheless, there is still plenty of room for hedge fund governance to improve. Accordingly, this Article provides a normative framework and principles for improving hedge fund governance by striking a better balance between governance devices that are investor-friendly and those that empower managers. My analysis suggests that the areas in which hedge fund governance needs the most improvement are performance reporting (valuation) and the timing of performance-fee calculations. Importantly, my analysis also suggests that investors may benefit from less disclosure, higher fees, and less access to their capital