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

Abstract

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 risk despite 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.

Keywords: CDS, CDO, Dodd Frank, Goldman Sachs, AIG, credit risk transfer, derivatives, securitization, regulation, governance, creditor, hedge funds, credit default swaps, collateralized debt obligations, collateralized loan obligations, commercial mortgage-backed securities, CLOs, CMBS, super senior