CLE Materials for Panel #1 - George Washington University Law ...

WILMARTH
4/1/2011 1:11 PM
2011] The Dodd-Frank Act 965
assembling pools of tranches from cash flow CDOs to construct
“CDOs-squared.” 37 The IMF estimated that private-sector financial
institutions issued about $15 trillion of ABS, MBS, and CDOs in
global markets between 2000 and 2007, including $9 trillion issued in
the United States. 38 Another study determined that $11 trillion of
structured-finance securities were outstanding in the U.S. market in
2008. 39
LCFIs intensified the risks of securitization by writing over-thecounter
(OTC) credit derivatives known as “credit default swaps”
(CDS). CDS provided “the equivalent of insurance against default
events” that might occur with reference to loans in securitized pools
or tranches of ABS, MBS and CDOs. 40 While CDS could be used for
hedging purposes, financial institutions and other investors
increasingly used CDS to speculate on the default risks of securitized
loans and structured-finance securities. 41 LCFIs further increased the
STOWELL, supra note 15, at 105–06, 456. As Frank Partnoy has noted, many CDOs
functioned as “‘second-level’ securitizations of ‘first-level’ mortgage-backed securities
(which were securitizations of mortgages).” Frank Partnoy, Overdependence on Credit
Ratings Was a Primary Cause of the Crisis 5 (Univ. San Diego Sch. of Law Legal Studies,
Research Paper No. 09-015, 2009), available at http://ssrn.com/abstract=1430653. CDOs
consisting of tranches of MBS are sometimes referred to as collateralized mortgage
obligations (CMOs) but are referred to herein as CDOs. See Benmelech & Dlugosz, supra
note 35, at 6.
37 LCFIs frequently used mezzanine tranches of CDOs to create CDOs-squared because
the mezzanine tranches were the least attractive (in terms of their risk-yield trade-off) to
most investors. Wilmarth, supra note 4, at 990–91, 1027–30; see also Scott, supra note
35, at 23–24, 24 fig.3. CDOs and CDOs-squared are sometimes hereinafter collectively
referred to as CDOs.
38 INT’L MONETARY FUND, supra note 11, at 84, 84 fig.2.2 & fig.2.3 (indicating that
$15.3 trillion of “private-label” issues of ABS, MBS, CDOs, and CDOs-squared were
issued in global markets between 2000 and 2007, of which $9.4 trillion was issued in the
United States). “Private-label” securitizations refer to asset-backed securities issued by
private-sector financial institutions, in contrast to securitizations created by governmentsponsored
enterprises such as Fannie Mae and Freddie Mac. Id. at 77 n.1; see also
Wilmarth, supra note 4, at 988–89.
39 Benmelech & Dlugosz, supra note 35, at 1.
40 Jeffrey Manns, Rating Risk After the Subprime Mortgage Crisis: A User Fee
Approach for Rating Agency Accountability, 87 N.C. L. REV. 1011, 1036–37 (2009); see
also Wilmarth, supra note 4, at 991–93, 1031–32; Viral V. Acharya et al., Centralized
Clearing for Credit Derivatives, in RESTORING FINANCIAL STABILITY, supra note 34, at
251, 254 (explaining that “a [CDS] is like an insurance contract”).
41 Crotty, supra note 33, at 569 (summarizing (1) a 2007 report by Fitch Ratings,
concluding that “58% of banks that buy and sell credit derivatives acknowledged that
‘trading’ or gambling is their ‘dominant’ motivation for operating in this market, whereas
less than 30% said that ‘hedging/credit risk management’ was their primary motive,” and
(2) a statement by New York Superintendent of Insurance Eric Dinallo, concluding that
“80% of the estimated $62 trillion in CDSs outstanding in 2008 were speculative”);