Vasudev JBL Paper

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  • 8/14/2019 Vasudev JBL Paper


    Credit Derivatives and RiskManagement: CorporateGovernance in theSarbanes-Oxley World

    P.M. Vasudev*

    [Keywords to Follow]

    Yet, ultimately, the ethics of American business depend on the conscience ofAmericas business leaders. We need men and women of character who knowthe difference between ambition and destructive greed, between justified riskand irresponsibility, between enterprise and fraud.

    George W. Bush (2002)1


    Credit derivatives were at the centre of the recent meltdowns in the investmentbanking and insurance sectors. This article analyses credit derivatives and theirrisks from the perspective of corporate governance. It discusses the gaps in thepresent structure of governance particularly, board involvement in monitoringbusiness and risk, and the scope of independent audit. The article proposesregulatory prescription of minimum board responsibilities and independentrisk assessment by experts.

    Contemporary corporate governance is based on the principle of multi-layeroversight by agencies, both internal and external. Typically, the different levels ofoversight in a public corporation would be: (1) senior management headed by thechief executive officer (CEO); (2) board committees; (3) board of directors; and(4) independent audit firm in that order. Recent events at major corporations inthe financial sector raise questions about the efficacy of this governance structure

    in understanding, assessing and managing the risk in credit derivatives.The article begins with an exposition of the characteristics of major creditderivatives collateralised debt obligations and credit default swaps. This is

    * Senior Lecturer,Department of Commercial Law,University of Auckland,New Zealand.1 Speech delivered in New York on July 9, 2002, available at http://custom.marketwatch.

    com/custom/earthlink-net/mw-news.asp?guid=78BC1B28-6171-4DD8-B7D7-0C10F6577E88 [Accessed March 10, 2009].



  • 8/14/2019 Vasudev JBL Paper


    P.M. Vasudev

    followed by an outline of how a new line of business, such as credit derivatives,wouldbe typically handled in the contemporary structureof corporate governance,which is based on the principle of disclosures and oversight. The article pointsout the ambiguities and gaps in the governance structure and explains how theyundermine corporate responsibility. The systemic weaknesses discussed in thearticle are quite evident from the failures on Wall Street and in the banking sectorin the recent months.

    The article treats good governance as an endogenous feature in corporations,rather than a product of the legal regime and the threat of sanction that is implicitin public regulation. This standard is consistent with: (1) the open structure ofcorporate law and its minimally intrusive character; and (2) the idea that the

    governance must be more a concern of the corporations, than regulation.2

    It is significant that the meltdowns have happened in the Sarbanes-Oxleyworld in which corporate governance is accepted, by and large, as a concernof public policy. The Sarbanes-Oxley Act of 20023 (SOX) has been presented ashaving a focus on corporate responsibility,4 and George Bush made the statements,extractedabove,while commendingthe Sarbanes-Oxley legislationin the aftermathof the corporate scandals that surfaced in 2001.

    The article makes a case for an alternative paradigm of corporate governancethat is based on responsibility, in addition to the current principle of oversight.The new paradigm would not interfere with business freedom. At the same time,it can promote responsible governance practices that are more responsible, paysufficient attention to risk and offer better protection against hazards. Specifically,the article proposes listing minimum board responsibilities, which would bemandatory functions of the boards of public companies. A second proposal is for

    mandatory risk assessment procedure in public companies, and consideration ofthe risk report by the board of directors as a part of their minimum responsibilities.

    Credit derivatives

    Credit derivatives were the major contributor to the crisis in the financial sector.This part provides an overview of two major credit derivatives, collateralised debtobligations and credit default swaps.5 The discussion explains the risk in theseinstruments and the implications for corporate governance.

    2 See, e.g. E. Norman Veasey, Should Corporate Law Inform Aspirations for GoodCorporate Governance Practices or Vice-Versa? (2001) 149 University of PennsylvaniaLaw Review 2179.


    Pub.L. 107-204, 116 Stat. 745.4 For opposition to SOX, see, e.g. Larry Ribstein, Market vs. Regulatory Responsesto Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002 (2003) 28 Journal ofCorporate Law 1. Ribstein argued that the statute is not effective but, at the same time,imposed significant costs on corporations.

    5 For a comprehensive discussion of collateralised debt obligations and credit defaultswaps, see Janet M. Tavakoli, Structured Finance and Collateralized Debt Obligations: NewDevelopments in Cash and Synthetic Securitization (Hoboken, N.J.: John Wiley & Sons,2008).



  • 8/14/2019 Vasudev JBL Paper


    Corporate Governance in the Sarbanes-Oxley World

    Collateralised debt obligations (CDO)

    CDO are pools of debt consisting of a number of loan obligations, which couldrange from corporate and municipal bonds to sub-prime mortgages. Owing toconsolidation, these pools of debt are more complex than simple loan transactionsor conventional debt securities. The following are the important characteristics ofCDO:

    CDO are treated as single consolidated pools of debt, rather than collectionsof individual debts. The focus is not on the individual components or loantransactions, but on tranches or slices of the entire pool. These tranches

    would, in themselves, contain more than one debt. Credit rating is an important element in CDO. The tranches of debt are rated

    for their credit standing by professional agencies, and that is the referencepoint for marketing CDO among investors.

    Since CDO are treated as consolidated pools of debt, the method of creditrating is different for them.6 The portfolio of debt is normally dividedinto three tranches: (1) equity or residual; (2) junior or subordinated ormezzanine; and (3) senior. Tranching would be based on the creditworthinessof the individual components. Typically, the senior tranche would consistof AAA rated debt securities.

    The focus is on cash-flow, which is the aggregate of interest and principalreceipts that accrue periodically to the portfolio over the duration of theCDO. Interest and principal repayments are not treated separately.

    The cash flow is allocated among the three levels or tranches senior, junior

    and equity levels in that order. This is the return for the investors. The seniortranche, which has the lowest risk, would also have the lowest return.

    The return is in the form of a spread above LIBOR (London inter-bankoffered rate) interest, and the senior segment would have the lowest spread.

    CDO were marketed among investors as having defined risk and reward,computed according to mathematical models.7 The focus was not on theunderlying debt securities.

    These characteristics are true of cash or balance-sheet CDO, which are fullyfunded and relatively straightforward. Here, an investment bank would arrangefor transfer of the underlying debt securities from the bank or other lendinginstitution to a special purpose entity (SPE), except for the equity or residualtranche, which the original lender would retain. Any defaults in this segment will

    be borne by the lender. The lenders retention of this most risky element, usually

    6 For a critical discussion on the credit rating of CDO, see Frank Partnoy and David A.Skeel Jr, The Promise and Perils of Credit Derivatives (2007) 75 University of CincinnatiLaw Review 1019.

    7 For a discussion on the pricing of CDO tranches, see Qiwen Chen, CDO Pricingand Copula Method, available at qchen/[Accessed March 10,2009].



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    P.M. Vasudev

    about 5 per cent of the total notional amount of the CDO and referred to astoxic waste, is a selling point for marketing the other tranches among investors.Figure 1 explains the cash CDO model, and shows the hierarchy among the CDOholders the equity, subordinated and senior tranches.CDO helps the bank or other lending institution to eliminate the debts fromits balance sheet. Transfer of debt and attendant credit risk, and the consequentreduction in regulatory capital are the incentives for the originating lender. Theability of the lenders to thus transfer their loan accounts was an important elementin the so-called sub-prime mortgage issue. It led to lower lending standards.Lenders could be more liberal in providing mortgage loans, and did not have toapply requisite caution in processing the loan applications.9

    There is yet another variety of CDO synthetic in which the originatingbank or other lender would merely transfer credit risk to the SPE, rather than theunderlying debt securities. The lender would retain the debt with itself. Synthetic

    Figure 1. Cash or balance sheet CDO8.

    8 Source:[Accessed March 10, 2009].9 See, e.g. Giovanni DellAriccia, Deniz Igan and Luc Laeven, Credit Booms and Lending

    Standards: Evidence from the Su