Putting together materials for the corporate finance class that is about to begin this upcoming week, I decided to include a chunk of this exceptionally clear, informative and well-argued article on credit derivatives - credit default swaps and collateralized debt obligations - by law professors David Skeel and Frank Partnoy. (The more I think about it, by the way, the longer the list of law professors in my mind who are contributing lots and lots to thinking through the post-financial crisis future.) I thought there might be some VC readers also on the lookout for something on this topic. The fact that it is from 2007, before everything came crashing down, makes it all the more interesting, particularly given the 'bright side" / "dark side" organization of the article. The pdf is a scan of the journal pages and takes a little time to download, but I think it is a great article both as scholarship and as a pedagogical tool. Here's the SSRN abstract:
The Promise and Perils of Credit Derivatives, 75 University of Cincinnati Law 1019 (2007)
In this Article, we begin what we believe will be a fruitful area of scholarly inquiry: an in-depth analysis of credit derivatives. We survey the benefits and risks of credit derivatives, particularly as the use of these instruments affect the role of banks and other creditors in corporate governance. We also hope to create a framework for a more general scholarly discussion of credit derivatives.
We define credit derivatives as financial instruments whose payoffs are linked in some way to a change in credit quality of an issuer or issuers. Our research suggests that there are two major categories of credit derivative. First, a credit default swap is a private contract in which private parties bet on a debt issuer's bankruptcy, default, or restructuring. For example, a bank that has loaned $10 million to a company might enter into a $10 million credit default swap with a third party for hedging purposes. If the company defaults on its debt, the bank will lose money on the loan, but make money on the swap; conversely, if the company does not default, the bank will make a payment to the third party, reducing its profits on the loan.
Second, a collateralized debt obligation (CDO) is a pool of debt contracts housed within a special purpose entity (SPE) whose capital structure is sliced and resold based on differences in credit quality. In a cash flow CDO, the SPE purchases a portfolio of outstanding debt issued by a range of companies, and finances its purchase by issuing its own financial instruments, including primarily debt but also equity. In a synthetic CDO, the SPE does not purchase actual bonds, but instead enters into several credit default swaps with a third party, to create synthetic exposure to the outstanding debt issued by a range of companies. The SPE finances its purchase by issuing financial instruments to investors, but these instruments are backed by credit default swaps rather than any actual bonds.
In the Article's first substantive part, we discuss the benefits associated with both types of credit derivatives, which include increased opportunities for hedging, increased liquidity, reduced transaction costs, and a deeper and potentially more efficient market for trading credit risk. We then discuss the risks associated with credit derivatives, such as moral hazard and other incentive problems, limited disclosure, potential systemic risk, high transaction costs, and the mispricing of credit. After considering the benefits and risks, we discuss some of the implications of our findings, and make some preliminary recommendations. In particular, we focus on the issues of disclosure, regulatory licenses associated with credit ratings, and the special treatment of derivatives in bankruptcy.
Consider, as an update, this pregnant paragraph - from 2007 - on what the CDO market was/is about:
In sum, CDOs present not only the numerous risks associated with credit default swaps, but also the risk that parties are spending billions of dollars in fees to buy mispriced debt. The potential market inefficiencies are substantial, given the size of the CDO market and the magnitude of CDO fees. There are two possibilities: either CDOs are being used to arbitrage a substantial price discrepancy in the fixed income markets or CDOs are being used to convert existing fixed income instruments that are priced accurately into new fixed income instruments that are overvalued. The first possibility assumes the existence of a substantial market inefficiency, perhaps the most substantial inefficiency ever found in the finance literature. The second possibility seems more likely. In other words, CDOs either are evidence of a substantial and pervasive market imperfection, or they are being used to create one. In the next we examine potential reforms, including suggestions for reducing the market distortions associated with CDOs. (emphasis added.)