Tuesday, December 29, 2009

REG FD-Stands for Fueling Disaster

There is a distinction to be made when examining REG-FD and comparing what the Securities Exchange Commission expects it to do, with what the effect of the regulation actually has.

Rise to Power

“We live again in a two-superpower world. There is the U.S. and there is Moody’s. The U.S. can destroy a country by levelling it with bombs: Moody’s can destroy a country by downgrading its bonds.”[i] In order to fully explain the role of the rating agencies in the current state of affairs, it is first necessary to provide a brief history of these companies and attempt to explain why they have so much power[ii].

A credit rating agency is a company that reviews a set of factors[iii] for certain types of debt obligations (such as a loan) and the underlying instrument itself. On many occasions, a rating agency will rate the issuer of the underlying debt as well. In theory, a rating agency exists to allow an objective third party to assess the credit worthiness of another person, entity or debt obligation.

An early form of rating agencies emerged in the nineteenth century when investors were dealing with failed railroads and skeptical land schemes.[iv] In 1868 Henry V. Poor released the first Manual of the Railroads of the United States, which reached five thousand subscribers by the early 1880s.[v] John Moody saw an opportunity[vi] because at that time, “A high percentage of corporation securities had to be bought on faith rather than knowledge.”[vii] Moody then went on to begin publishing his Manual of Industrial Statistics in 1900.

It wasn’t until 1909, that Moody began assessing creditworthiness, which was partially based “on the mercantile credit rating of retail businesses and wholesalers by companies like R.G. Dun and Company.”[viii]Materials on the history and development of rating agencies suggest that there were three phases of growth in both reputation and authority. The first phase, was in the early 1930s, when rating agencies became a requirement for selling any issue in the United States. From the 1930s to the 1980s, rating agencies became more prominent as a result of the U.S. bond market prevailing over a series of defaults by major sovereign borrowers.[ix]Rating agencies gained more power and influence as the high-yield junk bond market developed in the 1980s.

During the second phase, legislation was passed that gave the rating agencies broader power and authority over the investments that were made. “In 1975, the SEC further pulled ratings into the regulatory system through Rule 15c3-1, the net-capital rule…the rule gave ‘preferential treatment’ to bonds rated investment-grade by at least two ‘nationally recognized statistical rating organizations’ (NRSROs)…The SEC did not define the substance of an NRSRO in any detail.”[x] This act by the SEC helped to solidify the presence of rating agencies and made it incredibly difficult for other rating agencies to emerge in a meaningful way.

The act on the part of the SEC to create this fiction of NRSROs, has in effect, created a situation where issuers are not only buying the individual investor’s trust, but also the right to issue an item on the open market in a lucrative or meaningful way. Many, if not all regulations require at least one of the NRSROs to rate the issue investment-grade for it to be sold at all.[xi] Moreover, the potential for conflicts of interest to arise is heightened by the fact that rating agencies obtain their “valuable” information from the issuers themselves. So how then, is the rating truly independent, when the agencies themselves admit they haven’t always been?[xii]

Additionally, rating agencies do not conduct any of their own audits, but rather fully rely on the issuer’s “books”. Therefore, it is unclear as to whether the information that they receive from an issuer is even accurate. “Much of the responsibility-though not all-for the still smoldering subprime mortgage blaze falls on the shoulders of the three major bond rating companies. They assured the financial world that subprime mortgage bonds were golden investments; in fact, they were time bombs.”[xiii]

It is undeniable that rating agencies play a very significant and substantial role in the United States and by extension the global market place. As mentioned previously, a conflict of interest is inherent when the rating agencies are structured in a way that allows them, perhaps necessarily so, to receive their revenues from the issuers of financial instruments. This conflict is generally largely publicized when a high-rated company fails. For example, Enron, a company who was still rated at investment grade even four days prior to it’s declaration of bankruptcy, paid over $1.5 million annually to Moody’s alone.[xiv]

Attempts at Regulating CRAs

While the Sarbanes-Oxley Act[xv] required that the SEC come to a determination and report on whether additional regulation of NRSROs was necessary, the SEC later determined that they did not have the authority to regulate credit rating agencies. It was not until four years later that legislation was passed in attempts to regulate rating agencies that had achieved NRSRO status.

The Credit Rating Agency Reform Act of 2006[xvi] required that NRSROs register with the SEC and those who did, were subject to additional restrictions.[xvii] Most recently, the so-called “Paulson Blueprint”[xviii], released on March 12, 2008 also called for additional regulatory requirements to be imposed on rating agencies. These “actions” taken on the part of the government to step in, are a signal of change to come, but have done little to satiate critics of rating agencies.

Disaster Stemming from Disclosure

Legislators, in hopes to spur competition amongst rating agencies, have just passed a rule that will serve to create a larger risk of insider trading. [xix] The rule will require that companies disclose information to other rating agencies, even when those agencies have not provided a preliminary rating. One of the commission’s stated intentions for this rule is to prevent issuers from “shopping” for favorable ratings on their structured financial products.[xx] “The rule adopted last week says that whatever information is given to the agency hired by the issuer to rate the structured finance security must be given to other rating agencies, including those that provide analyses only to investors who pay for them. The result will be that analysts for the other rating agencies, like Egan-Jones Ratings, will have access to information not available to the general public, and their analyses will go only to clients. Those clients will have the benefit of nonpublic information, or at least of their agent’s analysis of what it means.”[xxi]

Expected Effects of New Rule & Conclusion

Because agencies are exempt under REG-FD, this serves as a recipe for disaster if the exemption is not removed. The “safeguards” that the commission has put in place amount to nothing more than hoping analysts will honor a promise not to disclose non-public information.

The rule does seemingly address its primary goal, which is to increase competition. However, if the safeguards in place are to rely on the good faith of rating analysts, the rule only increases potential risks. It has become increasingly more difficult to rely on rating agency reputations, and also increasingly more difficult to explain the purpose of these entities. Removing the exemption would go a long way to ensure fairness in the market. In addition, if rating agencies weren’t privy to non-public information, money managers who lost tons of money in collateralized debt obligations would not be able to use the fact that they relied on a rating as an excuse for their acting on bad assumptions.


[i] Thomas L. Friedman, New York Times, 1995

[ii] “As the free capital flowing through debt markets reaches new heights, the American rating agencies’ lever of upgrading, downgrading or putting on the “watch list” seems to have more weight than most international actions by the American government. But even the IMF [International Monetary Fund], as the only global institution with the power to infringe upon the sovereignty of even the biggest nations by carrying out its regular surveillance, looks weak compared with Wall Street’s mighty rating twins.” Klaus C. Engelen, International Economy, 1994.

[iii] “No complaint is more frequently voiced than the lack of clarity about what the ratings actually measure. While ratings are intended by the agencies to gauge the relative degrees of credit quality…how such factors are weighted-and-why-in making the final rating decision remains unclear.” John E. Petersen, The Rating Game: Report of the Twentieth Century Fund Task Force on Municipal Bond Credit Rating, 1974.

[iv] Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and The Politics of Creditworthiness. (Ithaca, NY: Cornell University Press).

[v] Ibid., at 23.

[vi] “somebody, sooner or later, will bring out an industrial statistical manual, and when it comes, it will be a gold mine.” Moody, John. (1933) The Long Road Home: An Autobiography . New York: Macmillan.

[vii] Moody, 1933, at 90.

[viii] Sinclair, 2005, at 24.

[ix] Sinclair, 2005, at 26.

[x] Sinclair, 2005, at 42.

[xi] “pursuant to the Secondary Mortgage Market Enhancement Act of 1984 (“SMMEA”) a security must, among other requirements, be rated in one of the two highest rating categories by at least one nationally-recognized rating organization to qualify as a ‘mortgage related security.’” Kenneth G. Lore & Cameron L. Cowan. Mortgage-Backed Securities Database on Westlaw.

[xii] Morgenson, Gretchen. (2008). “Credit Rating Agency Heads Grilled by Lawmakers” at http://www.nytimes.com/2008/10/23/business/economy/23rating.html?_r=1&pagewanted=print

[xiii] St. Louis Post-Dispatch. 2007 WLNR 21478758.

[xiv] Thomas L. Hazen and Jerry W. Markham. Broker-Dealer Operations Under Securities and Commodities Law Database on Westlaw.

[xv] Public Law No. 107-204, § 702, 16 Stat. 745 (2002).

[xvi] Public Law No. 109-291, 120 Stat. 1327, codified at 15 U.S.C.S. § 78o-7.

[xvii] “As part of that application, the NRSRO must disclose its performance measurement statistics, its rating methodologies, whether it has a code of ethics and financial statements were required to be supplied to the SEC periodically…tying practices such as requiring payment for additional services in order to obtain or retain a rating were prohibited.” Hazen and Markham, supra.

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Monday, June 29, 2009

The Role of the Rating Agencies


            Thomas L. Friedman stated, “we live again in a two-superpower world. There is the U.S. and there is Moody’s. The U.S. can destroy a country by levelling it with bombs: Moody’s can destroy a country by downgrading its bonds.”[i] In order to fully explain the role of the rating agencies in the current state of affairs, it is first necessary to provide a brief history of these companies and elucidate why they have so much power[ii].

            A credit rating agency (hereinafter rating agency) is a company that reviews a set of factors[iii] for certain types of debt obligations (such as a loan) and the underlying instrument itself. On many occasions a rating agency will also rate the issuer of the underlying debt as well. In theory, a rating agency exists to allow an objective third party to assess the credit worthiness of another person, entity or debt obligation.

            The concept of judging and weighing factors is nothing new. We, as individuals, make judgments about every aspect of our lives, down to the simplest of matters. The traditional concept of creditworthiness is, in essence, the same idea. An early form of rating agencies emerged in the nineteenth century when investors were dealing with failed railroads and skeptical land schemes.[iv] In 1868 Henry V. Poor released the first Manual of the Railroads of the United States, which reached five thousand subscribers by the early 1880s.[v] John Moody saw an opportunity[vi] because at that time, “A high percentage of corporation securities had to be bought on faith rather than knowledge.”[vii] Moody then went on to begin publishing his Manual of Industrial Statistics in 1900.

            It wasn’t until 1909, that Moody began assessing creditworthiness, which was partially based “on the mercantile credit rating of retail businesses and wholesalers by companies like R.G. Dun and Company.”[viii]Materials on the history and development of rating agencies suggest that there were three phases of growth in both reputation and authority. The first phase, was in the early 1930s, when rating agencies became a requirement for selling any issue in the United States. From the 1930s to the 1980s, rating agencies became more prominent as a result of the U.S. bond market prevailing over a series of defaults by major sovereign borrowers.[ix]Rating agencies gained more power and influence as the high-yield junk bond market developed in the 1980s.

            After this last phase, companies like Moody’s and Standard and Poor’s, became household names, and investors throughout the world came to rely on their judgments with increasing regularity. Rating agencies became a source of knowledge where investors could turn for  information regarding an issue or the issuer in the form of a grade. The grades are based on risk to the investor and range from AAA (or “triple A”) to D (for some rating agencies). Those that are considered “investment grade” range from triple A to BBB- (or “triple B minus”) with triple A being of the best quality and lowest risk. Bonds and preferred stock that are speculative are graded anywhere from BB+ to D and carry greater risks. [x][xi][xii]

            During the second phase, legislation was passed that gave the rating agencies broader power and authority over the investments that were made. “In 1975, the SEC further pulled ratings into the regulatory system through Rule 15c3-1, the net-capital rule…the rule gave ‘preferential treatment’ to bonds rated investment-grade by at least two ‘nationally recognized statistical rating organizations’ (NRSROs)…The SEC did not define the substance of an NRSRO in any detail.”[xiii] This act by the SEC helped to solidify the presence of rating agencies and made it incredibly difficult for other rating agencies to emerge in a meaningful way.

            One of the prevailing views of rating agencies is the “reputational capital” model. According to this framework, rating agencies are considered to be an essential function of the financial system. They serve as “reputational intermediaries” who monitor issuers and issues periodically to ensure that the grade is correct and accurate at a given point in time. This view can be applied in a general sense to individuals.

            “Individuals acquire reputations over time based on their behavior. If an individual’s reputation improves, and other members of society begin to hold that individual in higher esteem, that individual acquires a stock of reputational capital, a reserve of good will, on which other parties rely in transacting with that individual. Reputational capital leads parties to include ‘trust’ as a factor in their decision-making; trust enables parties to reduce the costs of reaching agreement. Reputational capital is especially valuable when a small number of actors interact repeatedly. In such situations, cooperation among individuals can prevail even without a government authority, as players learn information about other players’ strategies (i.e. their reputations).”[xiv]

However, an accountability gap exists in rating as a result of rating agencies not being heavily regulated. While the rating agencies do have a prominent interest in preserving their reputational capital (which creates an incentive to provide the best possible information to investors), the barriers to entry for competition allow them to continue with the oligopoly unopposed. What is most important to the rating agencies is the ability to continue their reign. As long as people continue to act collectively based on their beliefs about an agency, their job is done.

            Rating agencies have worked hard to establish a reputation for impartiality as “the success and function of a credit rating agency…depends on trust and credibility”[xv] and “credibility is fragile. [A rating agency] operates with no governmental mandate, subpoena powers, or any other official authority. It simply has a right, as part of the media, to express its opinions in the form of letter symbols.”[xvi]However, if this view is correct, a rating agency’s grade is nothing more than an opinion, and they can only survive in the business of rating if investors view them as being accurate and reliable.[xvii]

            Their integral role within the capital markets gives them significant knowledge and resources. Furthermore, even if some investors or individuals become skeptical about rating agency credibility, they cannot assume others in the markets have also become skeptical. The risk of that situation gives those that are skeptical more of an incentive to act based on this assumption that others are still reliant, and continue to “trust” the rating agencies. “Rating agencies should be understood therefore as a crucial nerve center in the world order, as a nexus of neoliberal control. They are agents of convergence who, along with other institutions, try to enforce “best practice” or “transparency” around the globe.” [xviii]

So why then, is there a problem? The problem first arose, when rating agencies began to charge those that issue these securities for their rating. There is an undeniably inherent conflict of interest in the current overall process of rating. In most scenarios, the individual who is primarily receiving the benefit or the service is the person who pays. With rating agencies, the investor is the person who is benefiting (for the most part) from the service of rating, but they bear none of the upfront costs (some argue that they bear the cost in the price of the issue). Rather, in this situation, the very entity issuing the item is the same entity that bears the cost, thereby increasing the potential for issuers to influence the judgment of these “impartial” rating agencies and consequently creates difficulty in allowing a rating to be an accurate resource of information.

In the past, rating agencies issued a rating to the individual investor for a fee[xix]. However, with the advances in technology that were made, and the vast increase in readily available information, rating agencies had a large free-rider problem. “Ratings are like the news-public goods. Once a rating is released, there is no way for the agency to prevent investors or intermediaries like banks, which have not paid for the rating, from free riding on the rating. The dilemma for the agencies is to reconcile the public-good aspect of ratings with the need to earn revenue and make an appropriate return.”[xx]The solution for this free-rider problem then, was to charge the issuer of the item.[xxi]

These changes in the rating process have caused a shift from the reputational capital view of rating agencies to a “regulatory license” view. “The regulatory license view is quite simple. Absent regulation incorporating ratings, the regulatory license view agrees with the reputational capital view: rating agencies sell information and survive based on their ability to accumulate and retain reputational capital. However, once regulation is passed that incorporates ratings, rating agencies begin to sell not only information but also the valuable property rights associated with compliance with that regulation.”[xxii]

The act on the part of the SEC to create this fiction of NRSROs, has in effect, created a situation where issuers are not only buying the individual investor’s trust, but also the right to issue an item on the open market in a lucrative or meaningful way. Many, if not all regulations require at least one of the NRSROs to rate the issue investment-grade for it to be sold at all.[xxiii] Moreover, the potential for conflicts of interest to arise is heightened by the fact that rating agencies obtain their “valuable” information from the issuers themselves. So how then, is the rating truly independent, when the agencies themselves admit they haven’t always been?[xxiv]

Additionally, rating agencies do not conduct any of their own audits, but rather fully rely on the issuer’s “books”. Therefore, it is unclear as to whether the information that they receive from an issuer is even accurate.


[i] Thomas L. Friedman, New York Times, 1995

[ii] “As the free capital flowing through debt markets reaches new heights, the American rating agencies’ lever of upgrading, downgrading or putting on the “watch list” seems to have more weight than most international actions by the American government. But even the IMF [International Monetary Fund], as the only global institution with the power to infringe upon the sovereignty of even the biggest nations by carrying out its regular surveillance, looks weak compared with Wall Street’s mighty rating twins.” Klaus C. Engelen, International Economy, 1994.

[iii] “No complaint is more frequently voiced than the lack of clarity about what the ratings actually measure. While ratings are intended by the agencies to gauge the relative degrees of credit quality…how such factors are weighted-and-why-in making the final rating decision remains unclear.” John E. Petersen, The Rating Game: Report of the Twentieth Century Fund Task Force on Municipal Bond Credit Rating, 1974.

 

[iv] Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and The Politics of Creditworthiness. (Ithaca, NY: Cornell University Press).

[v] Ibid., at 23.

[vi] “somebody, sooner or later, will bring out an industrial statistical manual, and when it comes, it will be a gold mine.” Moody, John. (1933) The Long Road Home: An Autobiography . New York: Macmillan.

[vii] Moody, 1933, at 90.

[viii] Sinclair, 2005, at 24.

[ix] Sinclair, 2005, at 26.

[xiii] Sinclair, 2005, at 42.

[xiv]Partnoy, 1999, at 629. Internal citations are omitted.

[xv] Partnoy, 1999, at 630.

[xvi] Standard & Poor’s Debt Ratings Criteria: Industrial Overview iii (1986) at 3.

[xvii] “According to this view, if S&P and Moody’s had not continued to generate quality information and their ratings had therefore become less accurate or reliable, they would have suffered a loss in reputation. Over time the agencies would have lost revenue, and perhaps been forced out of the rating industry. Assuming few barriers to entry in the credit rating business, new entrants would have displaced any agency suffering a loss of reputational capital. Such market forces would have acted  continuously on credit rating agencies, especially given the technological innovation in financial markets in recent decades, so that the playing field would have shifted constantly if agencies had not out-innovated and out-improved the competition. Therefore, the argument goes, Moody’s and S&P must have survived because of the quality of their ratings.” Partnoy, 1999, at 634-635.

[xviii] Sinclair, 2005.

[xix] “Rating agencies continued to accumulate reputational capital during the 1920s because they were able to gather and synthesize valuable information. During this time, ratings were financed entirely by subscription fees paid by investors, and the rating agencies competed to acquire their respective reputations for independence, integrity, and reliability. In a market with low barriers to entry, a rating agency issued inaccurate ratings at its peril. Every time an agency assigned a rating, that agency’s name, integrity, and credibility were subject to inspection and critique by the entire investment community.” Partnoy, 1999, at 640.

[xx] Ibid.

[xxi] “Perhaps the most important change in the credit rating agencies’ approach since the mid-1970s has been their means of generating revenue. Today, issuers, not investors, pay fees to the rating agencies…an agency publishing a rating to one or more individuals, for a fee, will find it difficult to exclude other non-paying individuals from access to that rating. Consequently, the agency should be able to collect higher fees. The agency also can solve the free-rider problem associated with the provision of a public good by having the issuer pay for the rating on behalf of all investors in the issue.” Partnoy, 1999, at 652.

[xxii] Partnoy, 1999, at 682.

[xxiii] “pursuant to the Secondary Mortgage Market Enhancement Act of 1984 (“SMMEA”) a security must, among other requirements, be rated in one of the two highest rating categories by at least one nationally-recognized rating organization to qualify as a ‘mortgage related security.’” Kenneth G. Lore & Cameron L. Cowan. Mortgage-Backed Securities Database on Westlaw.

[xxiv] Morgenson, Gretchen. (2008). “Credit Rating Agency Heads Grilled by Lawmakers” at http://www.nytimes.com/2008/10/23/business/economy/23rating.html?_r=1&pagewanted=print

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Tuesday, May 19, 2009

How Do Credit Default Swaps Factor into the Current Crisis

As mentioned previously, a CDS is a popular type of an unfunded credit derivative. This alone, may not have been a large problem. It was the combination of a number of factors, including something known as a collateralized debt obligation (hereinafter CDO). A CDO is generally defined as “an investment-grade security backed by a pool of bonds, loans and other assets.”[i] It is thought of as a type of asset-backed security (hereinafter ABS) that derives its value from a set of underlying assets.

Beginning in 2003 and continuing through 2006, the new CDOs backed by asset-backed and mortgage-backed securities grew increasingly exposed to subprime mortgage bonds. As individuals began to default at an increasing rate, the CDOs backed by these subprime mortgage bonds were downgraded in their rating and suffered large losses. This effect is commonly referred to as the “subprime mortgage crisis” because it signaled a beginning of the general downturn of the credit market. This downward trend has, in effect, limited the amount of mortgage credit that was generally available to homeowners. During this period, CDOs began to and continued purchasing portions of mortgage bonds that were much riskier but still had investment-grade ratings (we will revisit this in a subsequent section).

The CDO issuers were able to turn their risky mortgages and bonds into investment-grade “paper” by combining it with other assets. They then were able to sell these CDOs to investors on the open market. CDOs were attractive to buyers because they were investment-grade, and a higher rate of return then other “securities.” However, even while these CDOs were rated at investment grade, there is always some risk associated and that is where CDSs came into play.

CDSs were marketed by AIG’s Financial Products (hereinafter AIGFP) division in London as a form of “insurance” that would protect the holder of the CDO in the event of default. The man credited with inventing this use of the CDS is Joseph Cassano, a man who worked for Mike Milken (otherwise known as the Junk Bond King) in the Eighties. In theory, there is nothing wrong with using CDSs in this manner.

This method of using CDSs was designed so that investors who held CDOs would pay a premium to AIGFP, and in exchange, AIGFP agreed to cover the loss if the mortgage-backed CDO defaulted. This effectively moved the risk off of the table for investors holding a large amount of mortgage-backed CDOs, creating a boom in the market.

Remember however, that the seller of the CDS does not have to actually demonstrate that it can pay out on the guarantee. This allows sellers of CDSs to sell countless amounts of CDSs without having a single real asset to honor the obligation. Also, neither party actually holds the underlying loan, thereby allowing the CDS seller to sell “protection” to multiple parties for the same underlying mortgage.

As long as the probability of a default on the underlying security remained relatively unlikely, all parties involved could continue to collect high amounts of money. This was a win-win situation, until defaults became increasingly more common and AIG was expected to “payout” on the insurance.

And what did we expect when lending institutions were permitted to merge with commercial banks as a result of the Gramm-Leach-Bliley Act, making lending money in a predatory manner increasingly more common. Even individuals who had no income, no job, and no assets were permitted to borrow money and were actually expected not to default. NINJA[ii] loans became increasingly more accessible to borrowers, who then had the money to purchase a home they actually could not afford. What did we really expect to happen? We bet big, rolled the dice, and lost it all.


[ii] http://www.investopedia.com/terms/n/ninja-loan.asp “A slang term for a loan extended to a borrower with "no income, no job and no assets". Whereas most lenders require the borrower to show a stable stream of income or sufficient collateral, a NINJA loan ignores the verification process.”

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What is a Credit Default Swap?

Perhaps a question that some executives, politicians, investors and all taxpayers should have asked significantly sooner, is what is a credit default swap? In it’s simplest form, a credit default swap (hereinafter CDS) is a contract in which one party (the buyer) makes a series of small payments to another party (the seller). In return for the small payments, the buyer receives a lump sum if the instrument goes into default. Generally, CDSs are done with a bond or a loan as a credit instrument, and it is not necessary for the buyer to actually own the underlying bond or loan.[i]

Some have defined a CDS as being a credit derivative contract between two parties. [ii][iii] A credit derivative then, is defined as an instrument where the value is derived from the amount of risk on the underlying loan or bond. The reason that credit derivatives are popular is because the risk is shifted to an entity that is separate from the transaction. The third party or other entity is referred to as the reference entity and can be any institution or organization that has incurred some form of debt.[iv][v]The two parties to the contracts (buyer and seller) are agreeing to a form of protection against a risk associated with the reference entity. These risks can include: 1) bankruptcy; 2) payment default; 3) obligation default; 4) restructuring; and 5) where an obligation will be accelerated.[vi]

There are two major kinds of credit derivatives-unfunded credit derivatives and funded credit derivatives. An unfunded credit derivative can be defined as a contract between two parties in which each party has a responsibility to make payments without resorting to a use of other assets.[vii] A funded credit derivative, on the other hand, is where the party that is assuming the risk makes initial payments that are used to “settle” any potential events (such as default).[viii]

A CDS then, as mentioned previously, is a form of credit derivative. More specifically, it is a form of an unfunded credited derivative product. Some have likened a CDS to a form of insurance, and while there are some similarities between the two, there are also some significant differences. For example, the seller does not need to be a regulated entity; the seller is not required to maintain any reserves to pay off the buyers; and the buyer of a CDS does not necessarily have to own the underlying security[ix]. Another significant difference is the nature of how the parties manage the risk. Insurance companies or agents manage risk by setting “loss reserves” (the amount of money in the pool to pay off buyers upon the happening of a stated event) based on the Law of Large Numbers (hereinafter LLN)[x] whereas those who deal in CDS manage their risk in large part by hedging with other dealers in the bond market.

While a large majority of the public still believes that CDSs are a new phenomenon, they were actually invented by team working for JPMorgan Chase in 1997.[xi][xii] The CDS was created in large part to raise more capital, and were designed to shift the risk of obligation or payment default to a third party.[xiii] As mentioned previously, CDSs became largely freed from pervasive regulation by both the SEC and the Commodities Future Trading Commission (hereinafter CFTC) with the Commodity Futures Modernization Act of 2000 (an act also credited with the Enron loophole), when legislation was passed that ruled that credit default swaps were neither gaming nor a security and were therefore not subject to those constraints. 

In summation, if a CDS is not gambling, and is also not a security, it is not regulated as such.


[i] “In a credit swap, two parties agree to exchange cash flows based on the cash flows of a reference asset (e.g., the bonds of a risky borrower) and a reference rate (e.g., a comparable government security), or on the occurrence of a particular credit event.” Partnoy, Frank “The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies” Washington University Law Quarterly Fall 1999. 77 Wash. U.L.Q.619, 677.

[ii] CFA Institute. (2008). Derivatives and Alternative Investments. Page G-11. Boston: Pearson Custom Publishing.

[iii] “More specifically, a credit default swap is a bilateral financial contract in which one counterparty (the protection buyer) pays a periodic fee, typically expressed in fixed basis points as a percentage of the notional amount, in return for a floating payment contingent on the default of one or more third-party reference credits. This floating payment is designed to mirror the loss incurred by creditors of the reference credit in the event of default, and usually is calculated as the fall in price of a reference security below par at some pre-designated point in time after the reference credit has defaulted.” Partnoy, 1999, at 677.

[iv] Das, Satyajit (2005). Credit Derivatives: CDOs and Structured Credit Products, 3rd Edition. Wiley.

[vi] This is not an exhaustive list. There are other types of “events” that the parties to the contact can agree to include in the transaction.

[vii] Dominic O’Kane. “Credit Derivatives Explained”. Lehman Brothers, posted on Simon Fraser University website at http://www.sfu.ca/~sp6048/Reading/LEH%20O’Kane%20Credit%20Derivatives%20Explained%200301.pdf.

[viii] Id.

[ix] Mark Garbowski (2008-10-24). “United States: Credit Default Swaps: A Brief Insurance Primer” at http://www.mondaq.com/article.asp?articleid=68548.

[x] Please see http://www.probabilitytheory.info/topics/the_law_of_large_numbers.htm for a brief definition of the Law of Large Numbers generally.

[xi] David Teather. “The woman who built financial ‘Weapon of Mass Destruction.’” The Guardian at http://www.guardian.co.uk/business/2008/sep/20/wallstreet.banking?gusrc=rss&feed=business.

[xii] William Engdahl, “Credit Default Swaps The Next Crisis” at http://www.financialsense.com/editorials/engdahl/2008/0606.html.

[xiii] Taibbi, supra FN10.

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How the Crisis Came into Being

While the vast majority of individuals, both in America and abroad, are concerned (to put it lightly) over the economy, and are beginning to familiarize themselves with issues related to the financial crisis, a demystification of how the meltdown happened is necessary to ensuring that situations such as these are prevented in the future. Possibly the best method of explaining the economic crisis is to start with regulation.

Perhaps one of the most integral events that allowed the banking and economic crisis to occur was action taken by former United States Senator William Philip Gramm. He has been referred to as the ‘high priest of deregulation”[i] of the financial markets and lead efforts to pass the 1999 legislation known as the Gramm-Leach-Bliley Act. The Act, also known as Gramm-Leach-Bliley Financial Services Modernization Act[ii], is most widely credited with repealing certain portions of the Glass-Steagall Act[iii], and allowed investment banks and commercial banks to consolidate.

Some believe, rightly so, that this act was partly to blame for the subprime mortgage crisis and the current economic crisis. [iv][v] Then, a year later, the Commodity Futures Modernization Act of 2000, also spearheaded (or at the very least sponsored) by Former Senator Gramm, was passed. This act is credited by some with allowing the Enron Scandal to occur[vi] and prevented the government from regulating derivative transactions, including credit default swaps[vii], which ultimately led to the financial debacle we currently find ourselves in.

Also, through other legislation that was passed in 1999, certain companies could select the Office of Thrift Supervision (hereinafter OTS) as their regulator, as long as they owned at least one thrift (commonly called savings-and-loans). This allowed insurance giant American International Group (hereinafter AIG) to choose the OTS (a small agency by comparison to the Securities and Exchange Commission) to regulate them after purchasing a single thrift in Delaware.

This legislation allowed an agency with only one insurance specialist on staff to regulate the largest insurer in the world. It logically follows then that something would be overlooked. The combination of these acts paved the way for banks to purchase credit default swaps and the lack of regulation allowed freeing up of assets to run ramped.


[i] Paul Krugman (2008 Nobel Laureate in Economics)

[iii] Legislation that came out of the Great Depression era and established the Federal Deposit Insurance Corporation (FDIC) and kept banking, insurance and brokerage activities separate. The first Glass-Steagall Act was the first time that currency was allowed to be allocated to the Federal Reserve System. The second Glass-Steagall Act, known as the Banking Act of 1933 was responsible for the FDIC and bank separation. http://en.wikipedia.org/wiki/Glass-Steagall_Act#cite_note-7

[v] Matt Taibbi: The Big Takeover. The Rolling Stone, April 2, 2009 Issue

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Brief overview of moral hazard

Research suggests[i] that the term “moral hazard” dates all the way back to the 17th century, and was later utilized by insurance companies in England in the late 19th century. It was not until the 1960s that the concept was used in terms of the economy and was used to describe ineptitudes that potentially occur when risks are relocated.

            In more general terms, the concept of moral hazard describes the behavior of a party in a situation where the party is not fully exposed to the risk associated with the activity[ii]. Moral hazard occurs when a party (whether it be an individual or an organization) engages in activity less carefully than it would if it was required to bear the full responsibility and consequences of its actions. In essence, the party is less inclined to prevent an occurrence because they are somehow insulated from the negative consequences.

            The concept of moral hazard is not limited to the area of insurance agreements, but rather it is also applied to the courts interpreting contracts in a general sense. “According to Posner, the moral hazard problem arises when a party is ‘insured’ against a risk ‘that he could have prevented at a reasonable cost.’…undesirable incentives are created if a party that could have done something to avoid or minimize the loss is let off the hook by a court. Thus, when courts employ default rules to allocate risk among parties to a contract, the court is in a sense ‘writing insurance’ ex post. One implication of this is that courts, acting as an arbiter of risk by construing a contract, must be wary of creating conditions for moral hazard.”[iii] This definition of moral hazard and when it arises can offer a more contextual sense of the broad nature of the idea.

Some believe that moral hazard is a necessary evil of information asymmetry. The idea that a party to a transaction who has more information than another is shielded from risk makes sense and helps to explain the theory. The party with less information is then required to trust that the other party will behave appropriately, without ever knowing if that is the case. Therefore, it is logical that the concept of moral hazard has traditionally been applied in the insurance context[iv]. Moral hazard occurs when the insured party behaves in a manner that raises the cost on the part of the insurer as a result of the insured party’s insulation from all, or part of the risk.


[i] Dembe, Allard E. and Boden, Leslie I. (2000). “Moral Hazard: A Question of Morality?” New Solutions 2000 10 (3). 257-279

[iii] Eric D. Beal. “Posner and Moral Hazard”. 7 Conn. Ins. L.J. 81 (2001).

[iv] Arrow, Kenneth (1965). Aspects of the Theory of Risk Bearing. Finland: Yrjo Jahnssonin Saatio. OCLC 228221660. See also Arrow, Kenneth (1971). Essays in the Theory of Risk-Bearing. Chicago: Markham. 

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Sneak Preview

I recently wrote a paper for an independent study that I hope to convert into a law review article or note in the near future. I am posting the topic of the paper and will follow with paragraphs and snippets of the paper periodically. Enjoy!

The paper seeks to highlight the role of the rating agencies in the current financial crisis, gives an overview and layman’s guide explaining what occurred, relates how politics came into play that allowed it to occur, and how the concept of moral hazard applies to the so-called “bailout”. Lastly, the work offers suggestions as to what kinds of regulations should be implemented in order to mitigate the damage that has been caused as well as prevent situations like these from occurring. 

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