securitization and derivatives - standford edu.pdf
I think I actually understood what was written.
Fannie and Freddie were now crucial to the housing market, but their dual mis- sions—promoting mortgage lending while maximizing returns to shareholders— were problematic. Former Fannie CEO Daniel Mudd told the FCIC that ‘the GSE structure required the companies to maintain a fine balance between financial goals and what we call the mission goals … the root cause of the GSEs’ troubles lies with their business model.’ Former Freddie CEO Richard Syron concurred: ‘I don’t think it’s a good business model.’
A key OTC derivative in the financial crisis was the credit default swap (CDS), which offered the seller a little potential upside at the relatively small risk of a poten- tially large downside. The purchaser of a CDS transferred to the seller the default risk of an underlying debt. The debt security could be any bond or loan obligation. The CDS buyer made periodic payments to the seller during the life of the swap. In re- turn, the seller offered protection against default or specified ‘credit events’ such as a partial default. If a credit event such as a default occurred, the CDS seller would typi- cally pay the buyer the face value of the debt.
Credit default swaps were often compared to insurance: the seller was described as insuring against a default in the underlying asset. However, while similar to insurance, CDS escaped regulation by state insurance supervisors because they were treated as deregulated OTC derivatives. This made CDS very different from insurance in at least two important respects. First, only a person with an insurable interest can obtain an insurance policy. A car owner can insure only the car she owns—not her neighbor’s. But a CDS purchaser can use it to speculate on the default of a loan the purchaser does not own. These are often called ‘naked credit default swaps’ and can inflate potential losses and corresponding gains on the default of a loan or institution.
Before the CFMA was passed, there was uncertainty about whether or not state insurance regulators had authority over credit default swaps. In June , in re- sponse to a letter from the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP, the New York State Insurance Department determined that ‘naked’ credit default swaps did not count as insurance and were therefore not subject to regulation.