Current Developments in Monetary and Financial Law, Volume 6

Chapter 11: Regulating Credit Default Swaps in the Wake of the Subprime Crisis

International Monetary Fund. Legal Dept.
Published Date:
February 2013
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The subprime crisis focused much attention on credit default swaps (CDS) and the role they played in the failure of the American International Group Inc. (AIG). The bailout of AIG by the U.S. government was unprecedented in size and scope, and the amount of the bill to the taxpayers for that and other failures is yet to be tallied. The U.S. government, and those in Europe, are seeking to regulate the previously unregulated CDS market. To date, that effort has focused on the creation of central clearinghouses for CDS, which, it is hoped, will lead to greater transparency.1 The development of such clearinghouses is supported by the derivatives industry, and several clearinghouses have already been formed to carry out this activity. “Legacy” swaps are being registered with those clearinghouses and plans are underway for listing new originations. More troubling to the industry is the Obama administration’s request for broader, more intrusive, indeed pervasive, regulation of CDS by the Securities and Exchange Commission (SEC) and other over-the-counter (OTC) derivatives by the Commodity Futures Trading Commission (CFTC).2

This chapter will review the role played by CDS in the subprime crisis and the Great Panic of 2008. It will describe how the subprime crisis caused a sharp, probably unjustified, devaluation in the so-called “Super Senior” component of collateralized debt obligations (CDOs), which were at the heart of the crisis, and which in many instances were covered by CDS. This paper will also address ongoing governmental efforts to regulate the CDS market.

The Subprime Market

Growth of Subprime Lending

Historically, most commercial banks avoided subprime lending because of the credit risks associated with such loans.3 To avoid losses from subprime credits, large banks traditionally “redlined” areas of the communities where subprime borrowers lived, and refused to make mortgage loans in those areas.4 Minorities were often concentrated in the redlined areas, and this practice came to be viewed as racially discriminatory.5 In order to stop this practice, the Home Mortgage Disclosure Act of 1975 (HMDA)6 required banking institutions in metropolitan areas to disclose their mortgage loans by classification and geographic location. These disclosures were expected to reveal the existence of discriminatory lending patterns.

The Community Reinvestment Act (CRA) of 19777 went a step further than the HMDA. The CRA required affirmative action by banks in meeting the credit needs of minorities in their service areas. Loans to subprime areas were made a statutory condition by the CRA for receiving regulatory approval for bank mergers.8 However, that legislation did not prove to be immediately effective in expanding subprime lending. This was because bank merger activity was slow in the 1970s, and banks continued to shy away from the credit risks associated with such loans. The Clinton administration sought to overcome that resistance through its National Homeownership Strategy, which had as its goal to increase the percentage of owner occupied residences from 64 to 67.5 percent by the year 2000.9 That strategy was to be carried out by increasing the availability of subprime mortgages. That lending was to be motivated by additional CRA requirements that, “in the words of the Federal Reserve Governor who wrote the [new] regulations, set up soft quotas on lending in underserved areas.”10

The Clinton administration’s CRA efforts led to an eighty percent increase in the number of subprime mortgages.11 Clinton was aided by an increase in bank merger activity that motivated banks to make some massive CRA commitments. For example, Washington Mutual made a CRA pledge of $120 billion in its 1998 acquisition of HF Ahmanson & Co.12 The merger of Citibank and the Travelers Group in 1999 resulted in a ten-year $115 billion CRA pledge.13 The explosive growth of sub-prime CRA pledges carried over into the Bush administration. Bank of America made a ten-year CRA pledge of $750 billion when it merged with FleetBoston Financial Corp. in 2003.14 JPMorgan Chase made a larger $800 billion CRA pledge when it merged with Bank One Corp. in 2004.15 One website, which is highly critical of CRA pledges, claims that total CRA commitments by banks reached the astonishing figure of $4.2 trillion by 2004.16

After being forced into the subprime market by the federal government, banks found the business to their liking. This was another unfortunate legacy of the CRA. As former Senator Phil Gramm has noted: “It was not just that CRA and federal housing policy pressured lenders to make risky loans—but that they gave lenders the excuse and regulatory cover” to enter what was appearing to be a lucrative business in which risks could be managed through securitizations.17 Subprime lenders were initially an industry unto themselves because large banks avoided such lending until the CRA pushed them into it.

There were only ten lenders in the subprime market in 1994, but their numbers increased to fifty by 1998. By 2001, after motivation from the CRA, ten of the twenty-five largest subprime lenders were banks or bank affiliates.18

As a result of efforts by the Clinton administration, “[s]ubprime mortgage originations grew from $35 billion in 1994 to $140 billion in 2000, indicating an average annual growth rate of 26 percent.”19 Clinton certainly laid the groundwork for the subprime crisis, but subprime lending exploded during the years of the George W. Bush administration. As one source points out:

Some 80 percent of outstanding U.S. mortgages are prime, while 14 percent are subprime and 6 percent fall into the near-prime category. These numbers, however, mask the explosive growth of nonprime mortgages. Subprime and near-prime loans shot up from 9 percent of newly originated securitized mortgages in 2001 to 40 percent in 2006.20

The Federal Reserve Board has contended that the CRA did not cause the subprime crisis because many subprime loans did not have CRA credit.21 It has also been asserted that the CRA was not responsible for the subprime crisis because: (1) few CRA loan applications were denied, which it is claimed demonstrates they were good loans; (2) many of the players in the subprime market were not regulated banks; and (3) most subprime loans originated in California, Florida and Nevada, suggesting that, since CRA had little effect elsewhere, it was not to blame.22 These claims overlook the fact that the CRA required, and thereby legitimatized, subprime lending by institutions that had previously shied away from such risky loans. As former Fed Chairman Alan Greenspan testified before Congress in October 2008: “It’s instructive to go back to the early stages of the subprime market, which has essentially emerged out of the CRA.”23 Both the Clinton and Bush (43) administrations also pushed toward more subprime involvement by two giant government sponsored enterprises (“GSEs”), Fannie Mae and Freddie Mac. By 2000, about fifty percent of their portfolios were subprime products.24 This further legitimatized subprime lending by putting a government stamp of approval on these mortgages, as well as an implicit government guarantee.

Growth of the CDO Market

The Federal Reserve Board admonished banks that CRA loans were to be made in a safe and sound manner.25 That admonition begged the question of how do you make a safe and sound subprime loan when, as Fed Chairman Ben Bernanke has candidly admitted, those borrowers pose a “high credit risk?”26 The solution for this counterparty risk problem was solved by the Clinton administration when CRA regulations were amended in 1995 to allow CRA based subprime loans to be securitized. Securitization provided the banks with a way to move subprime loans off their balance sheets, and it allowed “lenders to shift mortgage credit risk and interest rate risk to investors who have greater risk tolerance.”27

The amount of securitized subprime mortgages grew from about $11 billion in 1994 to over $100 billion in 2002.28 Bear Stearns made its first subprime securitization offering in 1997 for mortgages totaling $385 million, and it underwrote an additional $1.9 billion in CRA securitizations over the next ten months.29 “By 2005, almost 68 percent of home mortgage originations were securitized.”30

The FDIC noted, in 2006, that: A significant development in the mortgage securities market is the recent and dramatic expansion of private-label, [mortgage-backed securities] MBS. Total outstanding private-label MBS represented 29 percent of total outstanding MBS in 2005, more than double the share in 2003. Of total private-label MBS issuance, two thirds comprised non-prime loans in 2005, up from 46 percent in 2003.31

The securitization process was carried out through CDOs that were distributed through “warehouse” operations, in which mortgages were purchased from non-bank originators by investment banks and then resold through securitizations. These warehousing operations became a part of an unregulated “shadow banking” system.32 A shareholder report by UBS AG described its CDO facility as follows:

In the initial stage of a CDO securitization, the [CDO] desk would typically enter into an agreement with a collateral manager. UBS sourced residential mortgage backed securities (“RMBS”) and other securities on behalf of the manager. These positions were held in a CDO Warehouse in anticipation of securitization into CDOs. Generally, while in the Warehouse, these positions would be on UBS’s books with exposure to market risk. Upon completion of the Warehouse, the securities were transferred to a CDO special-purpose vehicle, and structured into tranches. The CDO desk received structuring fees on the notional value of the deal, and focused on Mezzanine (“Mezz”) CDOs, which generated fees of approximately 125 to 150 bp (compared with high-grade CDOs, which generated fees of approximately 30 to 50 bp). …

Under normal market conditions, there would be a rise and fall in positions held in the CDO Warehouse line as assets were accumulated (“ramped up”) and then sold as CDOs. There was typically a lag of between 1 and 4 months between initial agreement with a collateral manager to buy assets, and the full ramping of a CDO Warehouse.33

Subprime CDOs were broken up into separate tranches. The less secure tranches were required to absorb any larger than expected losses from mortgage defaults, providing a cushion from loss for the most secure tranche, called the “Super-Senior.” As a result of this credit enhancement feature, the Super-Seniors were considered to be more credit-worthy than the underlying subprime mortgages themselves. The use of multiple payment stream tranches for a securitization was not a novel concept. “Collateralized mortgage obligations” (CMOs), also known as “real estate mortgage investment conduits” (REMICs), was a product that divided principal and interest payments from the mortgages placed in the pool into different payment streams.34

Mortgage principal and interest payments were not passed through to CMO investors pro rata, as was the case for the original GNMA pass through mortgage certificates.35 Instead, the CMO mortgage payments were divided into separate tranches with varying payment streams and with differing maturities, seniority, subordination, and other characteristics.36 The CMO market was crushed in 1994 after the Fed increased short-term interest rates for the first time in five years.37 Some of the tranches in the CMOs were so complex that Goldman Sachs had to use multiple supercomputers to run simulations of cash flows under different interest-rate scenarios.38 That problem presaged the valuation issues that would emerge during the subprime crisis in 2007.39

Growth of Credit Default Swaps


A CDS is an agreement by one party to make a series of payments to a counter party, in exchange for a payoff, if a specified credit instrument goes into default. As one court defined these instruments:

a common type of credit derivative in which the protection buyer makes a fixed payment to the protection seller in return for a payment that is contingent upon a ‘credit event’—such as a bankruptcy—occurring to the company that issued the security (the ‘reference entity’) or the security itself (the ‘reference obligation’). The contingent payment is often made against delivery of a ‘deliverable obligation’—usually the reference obligation or other security issued by the reference entity—by the protection buyer to the protection seller. This delivery is known as the ‘physical settlement.’40

Although CDS were widely used as a form of insurance against a default from that credit instrument, they were also used for speculation on whether a default will occur.41 It was estimated that eighty percent or more of the giant CDS market was speculative.42 The CDS, in all events, proved to be a popular instrument. Outstanding notional value of the CDS was over $42 trillion in debt at year-end 2007.43

CDS were used to enhance the creditworthiness of subprime securitizations.44 As an April 2008 UBS shareholder report noted, “[k]ey to the growth of the CDO structuring business was the development of the credit default swap (’CDS’). …”45 With the credit enhancement of a CDS, the credit rating agencies often gave the Super Seniors their highest triple-A rating. This was the same credit rating enjoyed by the federal government, which signaled to the world that a default on those Super Senior tranches was highly unlikely. Unfortunately, the rating agencies’ risk models for awarding the triple-A rating on CDOs did not take into account the possibility of a major downturn in the real estate market. That flaw was not spotted until the subprime crisis arose.

A risk model developed by David Li did for CDOs what the Black-Scholes model did for options. Seemingly, it allowed a supposed precise mathematical computation of the risks posed by these instruments. That and other Gaussian Copula risk models failed, however, to predict the massive losses sustained by commercial banks in the United States, and Europe, from their exposures to subprime CDOs.46 Fail they did, but there was no cabal using a secret formula to deceive investors. Moody’s actually published its CDO risk assessment model (CDOROM), which became the industry standard, on the Internet in 2004. The whole world was free to discover its flaws but, except for a few naysayers, the model went pretty much unchallenged.47

The mathematical model used to rate CDOs proved to be badly flawed.48 Critics charged that these models were defective because they relied on historical prices generated by a rising market. That Pollyanna approach overlooked the possibility of a hundred-year “perfect” storm, which arrived in the form of the subprime crisis. The possibility of such an unusual event was called a “fat tail” or “outlier.” They were also called “black swans,” as a metaphor for the widely held belief that there was no such thing as a black swan, until explorers reached Australia and found just such a bird.49 The probability of an outlier was considered so small that they were ignored by the credit assessors. Lloyd Blankfein, the CEO at Goldman Sachs, also asserted that many financial institutions had erred in outsourcing their risk management to the rating agencies. He believed that the rating agencies had diluted their triple-A rating by giving that rating to over 64,000 structured finance instruments, while only twelve operating companies in the world had such a rating.50

The high credit ratings given to the Super Senior tranches posed another problem. These securities were hard to market due to their lower interest rates, which was a function of their triple-A rating. That problem was solved after bank regulators in the United States allowed favorable capital treatment of Super Seniors on bank balance sheets, provided that the Super Senior had a triple-A credit rating.51 This regulatory blessing removed any residual concerns on the part of the banks of undue risk from Super-Seniors and created a demand for the Super Seniors by banks here and abroad. As a result, a large portion of the Super Senior tranches were held on the books of many major investment banks such as Citigroup, Merrill Lynch, UBS AG and Lehman Brothers. The twenty-five largest banks were also holding $13 trillion in CDS notionals on their books in March 2008.52

The AIG Debacle

A credit downgrade at the American International Group, Inc. (AIG) in September 2008 raised concerns that large losses would be experienced in the financial community if AIG defaulted on its $500 billion CDS portfolio. This spurred the federal government to mount a $183 billion rescue of that firm.53 AIG entered the CDS market in a big way in 2005 through its division called AIGFP, which had been founded by a group of traders from Drexel Burnham Lambert, the failed junk bond broker of Michael Milken fame.54 AIGFP’s risk model predicted that, based on historic default rates, the economy would have to fall into depression before AIG would experience losses from its CDS exposures.55 AIGFP assured investors in August 2007 that “it is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.”56

AIG’s share price dropped sharply after it reported a large 2007 fourth quarter loss that was accompanied by a $5.29 billion write-down of its mortgage related business, including a write-down of its credit CDS business by $4.88 billion.57 AIG reported a loss of $7.81 billion in the first quarter of 2008, largely due to a write down of $11 billion related to losses from Super Senior CDS written by the AIG Financial Products Corp. (AIGFP).58 Another $3.6 billion was written off by AIG for those instruments in the second quarter of 2008, adding to the $5.36 billion loss by AIG in that quarter.59 AIG reported a loss in the third quarter of $24.47 billion, including losses of $7.05 billion in AIGFP.60

Fed chairman Ben Bernanke turned AIG and the CDS market into a pariah when he declared in congressional testimony that nothing had made him more angry than the AIG failure, which he attributed to AIG’s exploitation of “a huge gap in the regulatory system.”61 He asserted that AIGFP was nothing more than a hedge fund attached to large and stable insurance company that “made huge numbers of irresponsible bets, [and] took huge losses. There was no regulatory oversight because there was a gap in the system.”62 Bernanke stated that the government was forced to expend billions of dollars to save AIG because its failure would have been “disastrous for the economy.”63

Actually, it appears that AIG’s failure was the result of credit downgrades, prompted by AIG’s write-downs of its CDS positions. Those write-downs were caused by a lack of a market that could accurately price the underlying Super Seniors. The subsequent credit downgrades caused large collateral calls that AIG did not have the liquidity to meet.64

AIG’s CEO, Martin Sullivan blamed mark-to-market accounting requirements for the losses sustained by AIGFP. Sullivan complained that AIG was required to markdown its inventories even though it had no intention of selling them.65 He may have had a point, as this was a common complaint in the industry.66 Fair value pricing was resulting in a pro-cyclical progression of write-downs that bore no relation to actual value. As Peter Wallison, an American Enterprise Institute Fellow, noted in the midst of the subprime crisis:

As losses mounted in subprime mortgage portfolios in mid-2007, lenders demanded more collateral. If the companies holding the assets did not have additional collateral to supply, they were compelled to sell the assets. These sales depressed the market for mortgage-backed securities (MBS) and also raised questions about the quality of the ratings these securities had previously received. Doubts about the quality of ratings for MBS raised questions about the quality of ratings for other asset-backed securities (ABS). Because of the complexity of many of the instruments out in the market, it also became difficult to determine where the real losses on MBS and ABS actually resided. As a result, trading in MBS and ABS came virtually to a halt and has remained at a standstill for almost a year. Meanwhile, continued withdrawal of financing sources has compelled the holders of ABS to sell them at distressed or liquidation prices, even though the underlying cash flows of these portfolios have not necessarily been seriously diminished. As more and more distress or liquidation sales occurred, asset prices declined further, and these declines created more lender demands for additional collateral, resulting in more distress or liquidation sales and more declines in asset values as measured on a mark-to-market basis. A downward spiral developed and is still operating.67

“The difficulty in putting a value on loans, securities, and exotic financial instruments banks were carrying on their books became one of the most debilitating features of the Great Panic” in 2008.68 Critics of fair value accounting charged that, because liquidity in subprime investments had dried up as the subprime crisis blossomed, the only prices available for “fair value” accounting were fire sale prices from desperate sellers. Those prices in no way reflected the actual value of the Super Seniors as measured by their cash flows or defaults. One accountant complained to the FASB that: “May the souls of those who developed FASB 157 burn in the seventh circle of Dante’s Hell.”69 Warren Buffett likened mark-to-market requirements for measuring bank regulatory capital to throwing “gasoline on the fire in terms of financial institutions.”70 Paul Volcker, the former Fed Chairman was also an opponent of fair value accounting for banks.71

The SEC gave some interpretative relief on September 23, 2008.72 The Emergency Economic Stabilization Act passed on October 3, 2008 required the SEC to conduct a study of mark-to-market accounting and authorized suspension of that requirement.73 However, a debate arose over whether a suspension was appropriate, and the SEC subsequently announced that it had decided not to suspend mark-to-market accounting.74 Its staff stated that: “Rather than a crisis precipitated by fair value accounting, the crisis was a ‘run on the bank’ at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm.”75

The Bank for International Settlements’ (BIS) Basel Committee on Banking Supervision published guidance on how banks should value financial instruments held in inventory. Its concern was that banks were using overly optimistic pricing models for instruments that did not have an ascertainable market price. BIS also wanted independent verification of prices.76 Actually, it later appeared that the banks had become too pessimistic during the subprime crisis in their valuations, valuing their subprime investment at prices lower than would be justified by a discounted cash flow analysis. Some horse back arithmetic seems to confirm this state of over-pessimism.

At the end of the first quarter in 2009, the delinquency rate for subprime mortgages, i.e., those with payments more than sixty days overdue, was sixteen percent,77 but CDOs had been sold for as little as twenty-one cents on the dollar.78 This defies explanation. Fifty percent or more of the value of the sixteen percent of homes foreclosed should be recovered in foreclosure proceedings. Moreover, the Super Seniors were modeled to withstand a loss in foreclosure of four percent or more,79 plus many Super Seniors had four percent or more in CDS coverage.80 Even adding in a big risk discount for the new junk bond status of these once triple-A Super Seniors does not justify the steep discounts at which these instruments were dumped on the market.

This analysis is, admittedly, over-simplistic, but it does seem to suggest that the massive write-downs of the Super Seniors were driven by panic and had no ties to the actual value of many of these securities. The experience at AIG is of some interest in this analysis. Gerry Pasciucco, a vice chair at Morgan Stanley, was brought in to wind down AIGFP.81 He determined that AIG had a notional $2.7 trillion for its swap contracts, and 50,000 outstanding trades with 2000 different firms. AIG was weakened after it wrote off some $20 billion in Super Senior CDS. AIG noted that these were marked-to-market unrealized losses due to fair value accounting and that it did not expect to have an actual material loss from these exposures.82

At the end of the second quarter in 2009, AIG posted a $184 million unrealized market gain on its super senior CDS portfolio, due mainly to the substantial decline in outstanding net notional amount resulting from the termination of contracts in the fourth quarter of 2008, as well as to the narrowing of corporate credit spreads.83 The effort to add some realism was aided by Moody’s and Standard & Poor’s, which agreed to assess not only the probability of a loss, but also the likely size of the loss. Unfortunately, that action came only after huge write downs had been taken that were based only on rating downgrades (down to junk bond status) that were based solely on the likelihood of a loss, without regard to the size of the loss.84

Regulation of Derivative Instruments

Some History

The regulation of derivative instruments in the United States began with commodity futures contracts.85 Although futures trading was occurring in Chicago before the Civil War, the commodity exchanges were largely untouched by federal regulation until the enactment of the Grain Futures Act of 1922 (“GFA”).86 The GFA limited commodity futures trading to “contract markets” licensed by the federal government.87 This requirement was intended to eliminate bucket shops and to require the registered contract markets to police their members in order to protect their licenses.

Further regulation was added by the Commodity Exchange Act of 1936 (CEA),88 after depressed grain prices were blamed on speculators operating on the commodity futures exchanges.89 The CEA prohibited commodity price manipulation,90 and sought to suppress trading in commodity options, which had been the subject of abuses.91 Exempted from its reach were transactions in “cash” or “actual” contracts and “forward” or “deferred delivery” contracts.92 The CEA continued to regulate the futures markets by requiring their registration and imposing duties on those exchanges to prevent manipulation. “Futures commission merchants,” which are brokerage firms that accept orders and funds from customers on the contract markets, were also required to register.93 This statute was administered by the Department of Agriculture.94

Turmoil in the commodity markets in the 1970s led to broader regulation over the commodity futures exchanges.95 That legislation, the Commodity Futures Trading Commission Act of 1974, created a new federal regulatory agency, the Commodity Futures Trading Commission (CFTC), which was intended to be the futures industry analogue to the SEC.96 The CFTC Act expanded the scope of the CEA to include all commodities, not just those that had been previously enumerated in the statute over the years, which swept up even futures contracts on financial instruments.97

Financial Futures

Soon after the CFTC was created, the Chicago Board of Trade introduced a futures contract on GNMA pass-through mortgage certificates that the CFTC approved. That contract was immediately successful and its success was followed by innovative futures contracts on stock indexes, such as the S&P 500 and later the Dow Jones indexes. The approval of those futures contracts, which the SEC viewed as securities industry products, set off a long-running war between the SEC and CFTC over who should have jurisdiction over such instruments.98

The SEC retaliated by seeking to have Congress remove jurisdiction from the CFTC over futures and options on securities products. In 1978, during the CFTC’s congressional reauthorization hearings, the SEC sought jurisdiction over futures contracts where the underlying “commodity” was a security. The Treasury Department also sought a regulatory role over futures contracts where the underlying commodity was a government security. The Congress rejected those requests, but did require the CFTC to “maintain communications” with the SEC, the Treasury Department and the Federal Reserve Board. Congress also instructed the CFTC to take into account the views of the Treasury Department and the Federal Reserve Board.99

The SEC did not take this defeat gracefully. It retaliated by approving the trading of GNMA options on the Chicago Board Options Exchange, Inc. (CBOE), which the SEC regulated, so that the securities industry could compete with the GNMA futures. However, the Seventh Circuit held that the CFTC had exclusive jurisdiction over such instruments, which meant they could not be traded on the CBOE.100 That litigation brought the SEC to the negotiating table. In 1982, the CFTC and SEC settled some of their jurisdictional differences through the so-called Shad-Johnson Accords, an agreement between the chairmen of the two agencies that was subsequently enacted into law.101 That agreement confirmed the CFTC’s authority to approve futures and options on futures contracts on broad-based indexes and allowed index options to be traded on the CBOE and other option exchanges regulated by the SEC. Jurisdiction over options trading on currency was split between the SEC and CFTC. The SEC was also given, in effect, veto power over new stock index futures contracts that had been approved by the CFTC. If the SEC exercised that power, then the CFTC could challenge it in court.102

The availability of futures contracts traded on stock indexes and other security products resulted in a great deal of trading by institutions that had previously shunned the commodity markets. A number of new computerized trading strategies were developed.103 Concern was raised that coupling these new financial futures with computerized trading programs might pose a danger to the markets because they might accentuate a market selloff—the “cascade theory.”104 Those concerns were found to be justified during the Stock Market Crash of 1987 when the Dow Jones Industrial Average dropped more in absolute and relative terms than the sell off in the Stock Market Crash of 1929.105

President Ronald Reagan created the Task Force on Market Mechanisms (the “Brady Commission”) that was headed by Nicholas Brady to determine the causes of the crash. The Brady Commission concluded that the uncertain division of regulatory jurisdiction between the SEC and the CFTC over futures products on securities was a culprit in the affair.106 The Brady Commission recommended that the Federal Reserve Board should be given the task of promulgating regulations that would cut across the securities and commodity markets.107 That recommendation was not followed.108

More New Products

Financial engineering became a phenomenon during the last three decades of the twentieth century. In addition to financial futures, a wave of new instruments appeared after the CFTC was created that contained elements of futures or options. The CFTC was faced with the issue of whether and how such instruments should be regulated. If CFTC jurisdiction had been applied to those instruments, the exchange-trading requirement in the CEA would have precluded their use because OTC dealers could not act as self-regulators or incur the expense of such regulation. In addition, institutional traders neither wanted nor needed the regulatory protection of the CEA.109

Swaps were of particular concern in this debate.110 The CFTC issued a policy statement in 1989 exempting swaps among institutions from regulation. There was, however, some uncertainty over whether the CFTC had the power to adopt such an exemption.111 To provide more certainty, the Futures Trading Practices Act of 1992 authorized the CFTC to exempt swaps, which it did.112 The swaps market then grew rapidly. Thereafter, Congress directed the Presidential Working Group on Financial Markets to conduct a study of the OTC derivatives market and make recommendations on whether it should be regulated. That report was issued in 1999113 and was followed by the enactment of the Commodity Futures Modernization Act of 2000 (CFMA).114 The CFMA exempted OTC instruments from regulation where the parties to the transactions were sophisticated counterparties. The exempted institutions included banks, investment bankers, pension funds, large businesses, and high net worth individuals.115

The CFMA created an exemption and exclusions from most regulation for electronic trading facilities used by institutional traders. These facilities were called “exempt commercial markets” (ECMs).116 The ECM exclusion was often referred to as the “Enron loophole.” This was because it was inserted into the CFMA at the last minute through the lobbying efforts of the Enron Corp., which was seeking to protect its popular electronic trading platform, EnronOnline, from regulation. Because of concerns over the explosion of energy prices in 2008, Congress closed the Enron loophole through amendments included in the CFTC Reauthorization Act of 2008.117

Regulating the CDS Market in the U.S.

The CDS market was unregulated before the subprime crisis, but the International Swaps and Derivatives Association, the industry trade group, provided a self-regulating structure for the business.118 Governmental intervention was occasionally required. The failure in 1998 of Long Term Capital Management (LTCM), a large hedge fund that had a large swaps book, raised systemic concerns. This led the Federal Reserve Bank in New York to arrange a rescue by a group of investment bankers. The Fed also pumped large amounts of funds into the money market during this period of uncertainty, which followed economic turmoil abroad during the so-called Asian Flu crisis.119 It was thought the Fed was signaling with that action that it would flood the market with liquidity whenever a large institution was about to fail, a monetary policy referred to as the “Greenspan put.”120

Following the failure of LTCM, twelve large banks formed the Counterparty Risk Management Policy Group (CRMPG) to assess whether improvements were needed in the swaps market. CRMPG was chaired by E. Gerald Corrigan, a managing director at Goldman Sachs and former president of the New York Fed. CRMPG issued a report in June 1999 that considered counterparty credit assessment; risk management; measurement and reporting; market practices and conventions; and regulatory reporting for swaps. It recommended improvements in internal firm policies and procedures for documentation; more standardization in market practices and conventions; improved ability to measure aggregate counterparty credit exposure and use of collateral as a risk mitigant; and use of stress tests to evaluate potential exposures.121

The CRMPG met again in 2005 with an expanded membership that included hedge funds and other money managers as well as the large banks. The CRMPG issued a report on July 27, 2005 that was amazingly prescient in predicting the precipitating factors and effects of a financial shock such as was experienced during the subprime crisis.122 The CRMPG described its goal of identifying additional measures to be taken by the financial community to promote the efficiency, effectiveness and stability of the global financial system. While Policy Group members recognized that financial disturbances occur from time to time and do not generally lead to widespread systemic risk, they noted that rare but potentially virulent financial shocks may occur with little, if any, warning. Such financial shocks can lead to sudden declines in asset prices and concerns about counterparty creditworthiness, position liquidations, and concerns about the adequacy of collateral, in turn causing liquidity to disappear as investors sell off positions.123

The swap market also encountered some concerns with its settlement practices. Because of the massive growth in trading volume in CDS there were significant backlogs in matching confirmations, which in many instances were done manually. The CRMPG recommended automating and integrating the transaction process through “straight through processing.”124 Another issue concerning the CDS market was the occurrence of disputes over whether trigger events had occurred that would require the credit protection seller to either pay up or provide additional collateral. To resolve such issues, ISDA developed a protocol that required participants to submit their dispute to a determination committee of investors and swap dealers. AIG refused to sign the protocol, preferring to negotiate its wind-downs bilaterally with each counterparty. This immensely complicated its problems when it was taken over by the federal government.

Demands for Regulation

The failure of Lehman Brothers during the height of the subprime crisis raised concerns that CDS written on its debt obligations could generate claims of up to $400 billion. However, that concern quickly dissipated after the obligations were netted, leaving an exposure of a more modest $5.2 billion. An auction was held to determine the value of Lehman’s bonds in bankruptcy, and they were valued at about $.08 on the dollar, which meant that the paying party on these credit default obligations would have to pay $.92 on the dollar. Those payments had to be made within two weeks. Those claims were settled quickly and in an orderly fashion.125 Similarly, outstanding CDS on bankrupt General Motors’ debt totaling $35 billion netted out to only $2.2 billion in exposure.126

A report from the senior financial supervisors of the G-7 nations concluded that the credit default swap market functioned well in the second half of 2008, despite “an unprecedented 12 credit events”—or actions that obliged the sellers of credit protection to make payments to those who had bought protection.127 Nevertheless, the AIG failure, which resulted in a U.S. Government bailout of over $180 billion, placed political pressure worldwide for regulation of the CDS market. Initially, that effort was directed at requiring CDS to be listed on a central clearinghouse that would provide transparency and credit protection.

The New York Federal Reserve Bank, while Timothy Geithner was its president, spearheaded that clearinghouse effort in the U.S., and he was supported in that effort by the large swap dealers. However, a Wall Street Journal editorial expressed concern with this proposal because it would centralize and socialize risk. The newspaper also objected to the proposed reliance by the New York Federal Reserve Bank on credit ratings as a basis for access to the central clearinghouse. The editorial noted that the market for credit default swaps was operating quite well despite the failure of Lehman Brothers and AIG.128

SEC Chairman Christopher Cox sought authority from Congress to regulate the credit default swap market in September 2008. He stated that the market lacked transparency and was ripe for fraud and manipulation.129 The claim of lack of transparency was becoming a new watchword for more regulation. No one could explain how transparency could have prevented the subprime crisis, or how it would add anything of value to the CDS market, and, worse still, nobody was asking that question. This demand also seems contrived since the Depository Trust & Clearing Corporation (DTCC) had established a Trade Information Warehouse (Warehouse), before the subprime crisis. It was “the only global repository and centralized post-trade processing infrastructure for over-the-counter (OTC) credit derivatives. The Warehouse maintains the vast majority of CDS contracts in the market place.”130 The DTCC was able to quickly calculate Lehman’s Brothers net exposure on its CDS at the time of its failure, removing concerns by confirming that losses would be less than $6 billion, rather than the $400 billion bandied about in the press.131

Nevertheless, the Presidential Working Group supported the effort for central clearing of standardized CDS,132 and Geithner continued pressing for its development after he was promoted to the position of Secretary of the Treasury.133 A group of the largest OTC dealers agreed in September 2009 with the New York Fed to submit at least eighty percent of “legacy” (previously entered into) CDS and ninety-five percent of new CDS trades to a central clearinghouse by October 2009. A similar agreement was reached on OTC interest rate derivatives.

A jurisdictional fight broke out among the SEC, CFTC and New York Federal Reserve Bank over who would approve and regulate such clearinghouses. These regulators tried to resolve this dispute through a memorandum of understanding that promised enhanced cooperation and information sharing among the Federal Reserve Board, the SEC and the CFTC, upon the development of such a facility.134 This truce did not last long, and the turf war continued. The SEC claimed that credit default swaps were securities subject to its jurisdiction. Using that regulatory handle, the SEC proposed to exempt from most of its regulation CDS clearinghouses that complied with its standards, including the exclusion of non-eligible swap participants.135

In the meantime, the effort to create an OTC clearinghouse turned into a competition among the larger exchanges seeking to grab market share. ICE, the CME, which had a joint venture with the Citadel Investor Group, the Clearing Corporation, which was formerly the clearing house for the Chicago Board of Trade, Eurex Clearing; and NYSE Euronext/Liffe/LCH Clearnet, were all separately rushing to create CDS clearinghouses.136

Additional Legislative Proposals

The Treasury Department sought legislation in June 2009 that would impose “robust” margin requirements for OTC derivatives and to otherwise broaden SEC and CFTC regulation of that market.137 The Financial Industry Regulatory Authority (FINRA) went a step further and began a pilot program establishing margin requirements for credit default swaps cleared by a central clearinghouse.138 The CFTC, however, had never before regulated margins; it was a matter left to the exchange clearinghouses, which set low margin rates, often less than five percent of the notional amount of the futures contract. The clearinghouse assures its own performance through an “initial” margin deposit deemed sufficient to assure performance and “variation” margin to reflect losses or gains in the position.139

The Obama administration submitted a lengthy legislative proposal to Congress, which seeks to repeal the regulatory exemption for swaps that was added to the CEA in 1992 and expanded in 2000. The proposed Obama administration legislation would require “standardized” OTC swaps to register on a regulated clearinghouse. A standardized swap would include any contract accepted by a clearinghouse and other contracts similar to those cleared by a clearinghouse.140 The proposed legislation grants the CFTC and SEC joint jurisdiction over derivatives but would also include bank regulators when banks are involved in such trading.141 The CFTC would have jurisdiction over non-security based swaps and broad-based indexes, while the SEC would regulate securities based swaps, including narrow indexes, single stocks and, most importantly, credit default swaps.

Both the CFTC and SEC would have jurisdiction over “mixed swaps,” which have elements of both securities and commodities. Swap dealers and “major swap participants” would be required to register with the agency that has jurisdiction in the market in which they operate, which will probably mean most large institutions will have to register with both the SEC and CFTC. These entities would be subject to capital and margin requirements, employee supervision requirements and a full panoply of regulations imposed by the SEC on broker-dealer and futures commission merchants by the CFTC.142 The derivatives industry is trying to forestall as much of this intrusive legislation as possible.

Other Intrusions

The SEC made another effort to bring credit default swaps under its wing by filing an insider trading case in May 2009 that involved credit default swaps. The SEC charged that Jon-Paul Rorech, a bond salesman at Deutsche Bank, passed inside information on to Renato Negrin, a hedge fund manager at Millennium Partners, who used the information to make a quick profit of $1.2 million.143 Adding further regulatory intrusion into this once unregulated market was an announcement in July 2009 that the Antitrust Division in the Justice Department was focusing on the credit default swap market. In particular, the Division was investigating the Markit Group Holdings Ltd, which was a company formed by a consortium of banks to collect pricing information that was used to create the ABX index to track subprime mortgages, and the CDX index for credit default swaps. The banks participating in this enterprise included Goldman Sachs and JPMorgan Chase.144

New York Attorney General Andrew Cuomo and U.S. Attorney Michael Garcia in Manhattan reached an agreement in October 2008 to jointly investigate the credit default swap market, which was showing few signs of any illegal activities. Cuomo was investigating whether swap dealers were manipulating the CDS market.145 Eric Dinallo, the New York State Superintendent of Insurance announced that a portion of the CDS market was subject to his regulation.146 Dinallo claimed that swaps with an actual risk of loss from the underlying security created an insurable interest that was being insured by the CDS.147 This theory did not extend to the more speculative “synthetic” CDS that did not involve the ownership of the actual underlying security. The National Association of Insurance Commissioners (NAIC), an organization of state insurance regulators, was also reversing its previous position on such instruments, announcing that it was considering whether it should regulate credit default swaps.148 NAIC noted that the credit default swap market had no central exchange, no capital requirements and no governmental oversight. This will undoubtedly result in even more layers of regulation.149

Regulating the CDS Market Abroad

The Group of 20

Concerns over CDS exposures were not limited to the United States. Banks in the European Union (“EU”) had been badly damaged by the triple-A rated “Super-Senior” subprime CDOs.150 Charlie McCreevy, the European Commissioner in charge of the Internal Market and Services, declared in October 2008 that an immediate goal of the Commission was to require central clearing of CDS. The Commission was seeking the prompt creation of a central registry for such instruments that would record credit derivative instruments after trades have been confirmed. This would create a “golden” copy of those transactions.151 That goal was accomplished on July 31, 2009 when CDS on European reference entities began clearing through central counterparties regulated in the EU.152

A Report of the High-Level Group on Financial Supervision in the EU,153 commonly referred to as “the de Larosière Report,” that was published in February 2009, called for the “simplification and standardization of most OTC derivatives and the development of appropriate risk-mitigation techniques plus transparency measures.”154 The de Larosière Report recommended strengthening the Level 3 committees on coordination of national regulators in the Lamfalussy process.155 It advocated the creation of a European Banking Authority, a European Insurance Authority and a European Securities Authority. These regulators would co-ordinate and arbitrate among national supervision regarding cross-border financial institutions; take steps to move towards a common European rulebook; and directly supervise the credit rating agencies.156

Legislative proposals for implementing these recommendations were issued by the European Commission in September 2009.157 However, concerns were being raised over whether these regulators would interfere in the fiscal affairs of the individual member states. The proposed legislation would also create a European Systemic Risk Board, which would be composed of the twenty-seven central bank governors from the EU member states.158 The de Larosière Report further recommended the creation of at least one well-capitalized “central counter party” (“CCP”), a.k.a. clearinghouse, to be supervised by the Committee of European Securities Regulators (“CESR”) and the European Central Bank (“ECB”).159

The de Larosière Report called for “international level issuers of complex securities to retain on their books for the life of the instrument a meaningful amount of the underlying risk (non-hedged).”160 Regulators in the EU were also pressing for the immediate creation of a European based warehouse for CDS. They were seeking a central registry for such instruments that would record credit derivative instruments after trades have been confirmed. This would create a “golden” copy of those transactions.161 EU market participants were already acting on some of these recommendations. By July 2009, CDS dealers committed to start clearing eligible CDS on European reference entities and indices on these entities through one or more European CCP.162

The European Commission has also identified four main goals for improving financial stability by regulating OTC derivatives markets:

a) allow regulators and supervisors to have full knowledge about the transactions that take place in OTC derivatives markets[,] as well as the positions that are building in those markets; b) increase the transparency of OTC derivatives markets vis-à-vis their users; in particular more and better information about prices and volumes should be available; c) strengthen the operational efficiency of derivatives markets so as to ensure that OTC derivatives do not harm financial stability[;] and d) mitigate counterparty risks and promote centralized structures.163

To achieve these goals, the EC wishes to use the following tactics: “(i) promoting further standardization, (ii) using central data repositories, (iii) moving to CCP clearing, and (iv) moving trading to more public trading venues.”164

Regarding standardization, the European Commission would like to see as many CDS standardized as possible so that, ultimately, they could all be cleared through a clearinghouse.165 It views this as “a core building block in the Commission’s endeavor to make derivatives markets efficient, safe and sound.”166 Some industry groups (e.g., The European Association of Corporate Treasurers (“ACT”)), however, see standardization as potentially harmful to non-financial companies that use financial derivatives for hedging purposes and whose trading does not have a significant effect on global risk.167 ACT is concerned that companies with moderate treasury risk may forego hedging because of the collateral exposure and thus remain exposed to volatility and other risks.168

The Leaders’ Statement from the Group of 20 summit in Pittsburgh, PA, also called for standardized OTC derivative contracts to be traded on exchanges or electronic trading platforms, where appropriate, and cleared through CCP by year-end 2012. The Group of 20 wanted other OTC derivative contracts to be reported to trade repositories and that non-centrally cleared contracts be subjected to higher capital requirements.”169 To coordinate financial markets reform around the world, the Group of 20 also established the Financial Stability Board (FSB).170 The Group of 20 requested the “FSB and its relevant members to regularly assess implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.”171

The United Kingdom

In London, the Financial Services Authority (“FSA”) was strongly supporting the objective of achieving robust and resilient central clearing house arrangements for CDS clearing.”172 The March 2009 Turner Review, drafted by FSA Chairman Lord Jonathan Adair Turner, recognized, however, that the impact of central clearing arrangements should not be overstated because “clearing and CCP systems will only be feasible for the roughly 50–75 percent of the CDS which is accounted for by standardized contracts.”173 This statement acknowledges that a large volume of CDSs might continue to trade OTC.

In a Discussion Paper published by the FSA concurrently with the Turner Review, the FSA noted that it does not cite a “lack of transparency around trading activity in OTC instruments” as a cause of the subprime crisis.174 However, the FSA believed transparency might need to be enhanced to strengthen markets for the future and was working with counterparts in the International Organization of Securities Commissioners (IOSCO) and to Committee of European Securities Regulators (CESR) to that end.175

The Chancellor of the Exchequer also weighed in on the regulation of CDS and other OTC derivatives, in his own report.176 “To enhance the robustness and functioning of key derivatives markets, the Chancellor recently called for an EU Clearing and Settlement Directive to bring CCPs within a harmonized EU legislative framework, including CCPs for derivatives.”177 HM Treasury also believed that standardized, liquid and price-transparent OTC derivatives should be cleared on CCPs, while counterparty risk for illiquid or new products unsuitable for clearing on a CCP should be mitigated through bilateral collateralization and risk-based capital charges.178 In addition, HM Treasury asserted that non-CCP cleared derivatives should be reported to a trade repository and be made available to regulators.179


Japan enacted its Financial Instruments and Exchange Law (“FIEL”) just in time for the subprime crisis.180 The FIEL consolidated four other statutes including those regulating financial futures and the mortgage-backed securities.181 The Japanese Financial Services Authority (JFSA) was given authority over, “not only derivatives related to securities but also derivatives related to other financial instruments, and the FIEL covers derivatives that are transacted on a Japanese or foreign exchange or over the counter.”182

FIEL did not address central clearing of derivatives.183 A committee of the Tokyo Financial Exchange (TFX)184 did consider the issue of using a central counterparty to clear OTC derivatives.185 The committee’s report identifies the Tokyo Financial Exchange (“TFX”) as the most likely institution for clearing OTC transactions, given it “is the only exchange in Japan that specializes in trading and clearing financial derivatives”186 and its members (including major financial institutions in Japan, the United States, and Europe) have the credit quality required to successfully establish a CCP at the TFX.187 The report identifies the following benefits of having a CCP: (1) reduced counterparty risk and thus less use of credit lines; (2) reduction of the risk portion of the capital adequacy ratio; (3) standardized processing reducing operational risk; and (4) reduced systemic market risk.188

The conclusion of the committee was to proceed with setting up a clearing house for interest rate swaps and CDSs.189 The TFX committee resolved to set the schedule to establish a functioning CCP for OTC transactions in Japan in 2010. 190 Interest rate swaps will be cleared immediately, but the committee was more cautious about CDS, stating that it would be better to wait and see what kind of CCP system is successfully adopted and supported by the market place in Europe and the U.S.191


The Final Report of IOSCO’s Technical Committee of the Task Force on Unregulated Financial Markets and Products (TFUMP) addressed the regulation of CDS.192 This committee was formed at the behest of the Group of 20 to “review the scope of financial regulation with ‘a special emphasis on institutions, instruments and markets that are currently unregulated, along with ensuring all systemically important institutions are appropriately regulated.’”193 The committee’s report identifies three main issues related to CDS: counterparty risk, lack of transparency, and operational risk.194 The recommendations of the committee echo many of those made by U.S., U.K. and EU officials concerning the regulation of financial derivatives, including the use of a central counterparty for CDS.


The CDS market has, rightly or wrongly, been fingered as a prime culprit in the subprime crisis. The regulatory solution worldwide has been to require CDS to be traded or listed on a CCP. The focus on CDS clearing, however, seems odd since the Depository Trust & Clearing Corporation was operating its Trade Information Warehouse before the subprime crisis. That Warehouse maintained the vast majority of CDS contracts in the market place and appears to have functioned well during the crisis. Perhaps, a clearinghouse could add a guarantee function, but that would only concentrate systemic risk. The focus on CDS clearing may also prove to be unfortunate if it diverts attention away from some more serious concerns raised by the subprime crisis. Examining the role of government housing and interest rate policies and fair value accounting requirements in that crisis certainly appear to deserve more attention.

Another diversion has been the focus on compensation practices at financial services firms that purportedly caused them to take on “excessive” risk. Actually, a large percentage of the losses at the large banks during the subprime crisis were attributable to the Super Senior tranches of the subprime CDOs. For example, 50 percent of UBS AG’s $18.7 billion in write-offs from U.S. mortgage exposure was due to Super Seniors.195 Merrill Lynch’s U.S. CDO subprime net exposure consisted primarily of its Super Senior CDO portfolio.196 As of September 30, 2007, Citigroup held “approximately $55 billion in U.S. subprime direct exposure, $43 billion of which was due to exposures in the most Super Senior tranches of CDOs.”197 Of Citigroup’s $14.3 billion pretax loss (net of hedges) in 2008 from subprime-related direct exposure, $12 billion was attributable to “net exposures to the super senior tranches of CDOs … derivatives on asset-backed securities or both.”198

As described above AIG believed that it faced little or no risk from its Super Senior CDS portfolio, which became the centerpiece of its problems during the subprime crisis.199 The Super Seniors had a triple-A rating and their comparably low rate of return reflected that risk assessment.200 That triple-A rating, even if flawed in its analysis, was a gold standard seal of approval that declared the Super Seniors to be the safest of investments. Because of that favorable rating, regulators gave the Super Seniors favorable capital treatment when held on the books of banks. The banks and AIG believed, with the support of what they thought were the best analytical minds in the world, that these were the safest of investments.

The rating agencies downgrades of the Super Seniors raised issues of flawed risk models, not risk-based bonuses. The near across the board failure of risk models for subprime debt raises an issue that needs addressing. A Nobel Prize awaits the solution of the conundrum posed by the Black Swan. How do we create a risk model that takes into account the worst-case scenario, i.e., that the instrument at risk will become worthless, while at the same time allowing investors to make a reasoned assessment of what they believe to be the reasonably expected risk?

Jeremy Grant & Nikki Tait, “Plan for European CDS Clearer Opposed,” Financial Times (London), Feb. 6, 2009, at 27.

See Sarah N. Lynch, “SEC Seeks More Credit-Swaps Power,” Wall St. Journal, Sept. 23, 2009, at C3.

A subprime loan is one that has a high likelihood of default because the borrower is not creditworthy. Although there are no uniform standards for classifying a mortgage as subprime, a loan is generally viewed to be such if the borrower falls within one of the following categories: (1) those with a poor credit history; (2) those with no credit history; and (3) borrowers who have existing credit, but who are over extended. See Note, “The Entrance of Banks Into Subprime Lending: First Union and the Money Store,” 3 N.C. Banking Inst. 149, 150-51 (1999). FICO credit scores are also used to identify subprime borrowers. See In re Countrywide Fin. Corp. Sec. Litig., 2008 U.S. Dist. LEXIS 102000 (C.D. Cal. 2008).

The Federal Housing Administration (“FHA”) had employed a similar practice of denying mortgage insurance in poorer communities. See Ngai Pindell, “Is There Hope for HOPE VI?: Community Economic Development and Localism,” 35 Conn. L. Rev. 385, 399 n.76 (2003) (“The FHA extended the segmentation of neighborhoods through redlining. In providing insurance to private lenders for long-term mortgage loans, the FHA disfavored areas occupied by racial minorities.”) That practice was later changed to direct FHA insurance to subprime borrowers. See Kerry D. Vandell, “FHA Restructuring Proposals: Alternatives and Implications,” 6 Housing Pol’y Debate 299 (1995).

See generally National State Bank v. Long, 630 F.2d 981(3rd Cir. 1980) (describing this practice).

Home Mortgage Disclosure Act of 1975, Pub. L. 94-200, 89 Stat. 1125 (codified at 12 U.S.C. §§ 2801-2811 (2006)).

Community Reinvestment Act of 1977, Pub. L. 95-128, 91 Stat. 1147 (codified at 12 U.S.C. §§ 2901 et seq. (2006)).

See generally Joseph Moore, “Community Reinvestment Act and Its Impact on Bank Mergers,” 1 N.C. Banking Inst. 412 (1997) (describing this legislation and the problems it engendered).

See President William J. Clinton, Remarks on the National Homeownership Strategy, June 5, 1995, at the White House, available at The American Presidency Project,

Roberta Achtenberg, a HUD assistant secretary established a nationwide CRA enforcement program that was designed to force banks to make sub-prime loans. As one author asserts:

Banks were compelled to jump into line, and soon they were making thousands of loans without any cash-down deposits whatsoever, an unprecedented situation. Mortgage officers inside the banks were forced to bend or break their own rules in order to achieve a good Community Reinvestment Act rating, which would please the administration by demonstrating generosity to underprivileged borrowers even if they might default. Easy mortgages were the invention of Bill Clinton’s Democrats.

Lawrence G. McDonald & Patrick Robinson, A Colossal Failure of Common Sense 4 (2009).

See Jaret Seiberg, “Minority Report,” The Daily Deal, Nov. 3, 2003.

See Lissa L. Broome and Jerry W. Markham, Regulation of Banking Financial Service Activities, Cases and Materials, 405-406 (3d ed. 2008) [hereinafter Regulation of Banking].

See Craig Lender, “In Brief: B of A Chief Raps CRA Overhaul,” Am. Banker, Apr. 26, 2004, at 8.

See Regulation of Banking, supra note 14, at 405-406.

See Steve Sailer, The Minority Mortgage Meltdown (cont.): Charting the CRA Crackup,, Feb. 15, 2009, (last visited Nov. 12, 2009).

Phil Gramm, “Deregulation and the Financial Panic,” Wall St. Journal, Feb. 20, 2009, at A17.

See Regulation of Banking, supra note 14 at 412.

Subprime Mortgage Lending and the Capital Markets, RBSF Economic Letter, Dec.28, 2001, (last visited Oct. 25, 2009).

Danielle DiMartino and John V. Duca, “The Rise and Fall of Subprime Mortgages,” 2 Econ. Letter—Insights from the Fed. Reserve Bank of Dallas 11, available at

See Randall S. Kroszner, Fed. Reserve Gov., “The Community Reinvestment Act and the Recent Mortgage Crisis,” Address Before the Confronting Concentrated Poverty Policy Forum (Dec. 3, 2008).

See Charles E. Day, “Stripping Off Market Accountability: Housing Policy Perspectives on the Crisis in the Financial System,” 13 N.C. Bank. Inst., 105, 110-111 (2009).

Phil Gramm, “Deregulation and the Financial Panic,” Wall St. Journal, Feb. 20, 2009, at A17. The newest twist on the CRA was Goldman Sach’s announcement that it was giving $500 million to aid small businesses. That announcement was designed to deflect criticism of its massive bonus pool, but critics noted that this contribution would also allow Goldman, which had converted to a bank holding company during the crisis, to meet its CRA needs in future years. Francesco Guerrera and Tom Braithwaite, “Goldman Boost From Business Aid Fund,” Financial Times (London), Nov. 20, 2009, at 15.

See “The Subprime Lending Bias,” Investor’s Bus. Daily, Dec. 22, 2008, at A14. That quota was increased to fifty-two percent in 2005. See William D. Cohan, House of Cards 297 (2009).

See Federal Reserve Board: Community Reinvestment Act, (last visited Nov. 12, 2009) (“Nor does the law require institutions to make high-risk loans that jeopardize their safety. To the contrary, the law makes it clear that an institution’s CRA activities should be undertaken in a safe and sound manner.”).

Ben S. Bernanke, Chairman, Federal Reserve Board, “The Subprime Mortgage Market,” Address Before the Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and Competition (May 17, 2007).

Division of Insurance and Research of the Federal Deposit Insurance Corporation, “Breaking New Ground in U.S. Mortgage Lending,” FDIC Outlook (Fed. Deposit Ins. Corp.), Summer 2006, at 21.

See Roberto Quercia, Michael Stegman, & Walt The Davis, “Assessing the Impact of North Carolina’s Predatory Lending Law,” 15 Housing Pol’y Debate 2 (2004).

See Cohan, supra note 25, at 297.

FDIC, “Breaking New Ground in U.S. Mortgage Lending” FDIC Outlook 21 (Summer 2006) (emphasis supplied).


These warehousing operations often involved the purchase on non-bank subprime mortgage originations by investment banks like Bear Stearns and Merrill Lynch. See Paul Muolo & Mathew Padilla, Chain of Blame (2008) (describing these warehousing operations).

UBS AG, Shareholder Report on UBS’s Write-Downs § 4.22 (2008).

This product was created in 1983 for Freddie Mac by Larry Fink, now the head of BlackRock Inc., the giant asset manager. Charles Morris, The Trillion Dollar Meltdown 39 (2008).

Those certificates involved the pooling of a bundle of mortgages into a trust or other special-purpose entity. Certificates of ownership were then sold in that pool. The certificate holders were paid the monthly mortgage payments in aliquot portions from the pool. The value of these certificates would fluctuate as interest rates changed. For a description of the GNMA pass-through securities see Rockford Life Insurance Co. v. Ill. Dept. of Revenue, 482 U.S. 316 (1987).

See Banca Cremi, S.A. v. Alexander Brown & Sons, Inc., 132 F.3d 1017 (4th Cir. 1997) (describing CMOs).

See Morris, supra note 35, at 39-43.

CMOs often contained exotic tranches, including inverse floaters and inverse interest-only strips that converted fixed rate mortgages into floating rate tranches. Inverse floaters had a set principal amount and earned interest at a rate that moved inversely to a specified floating index rate. The principal amount on which that interest rate was calculated was determined by reference to the outstanding principal amount of another tranche. As the reference tranche was paid off, the principal on which the inverse interest-only strip earned interest decreased. A rate increase reduced the inverse interest-only floating rate, but also extended its maturity and, thereby, increased total interest payments. These tranches were deemed necessary in order to cover the effects of increases in interest rates, which caused their maturity date to expand. Inverse floaters could receive high returns if interest rates declined or remained constant, but suffer large losses if interest rates decreased. Inverse interest-only strips did not receive principal payments. These floaters were leveraged, so that a small increase in interest rates would cause a dramatic decrease in the inverse floating-rate. See Banca Cremi, S.A. v. Alexander Brown & Sons, Inc., 132 F.3d 1017 (4th Cir. 1997) (describing CMOs).

See Jerry W. Markham, A Financial History of the United States, From the Age of Derivatives to the New Millennium (1970-2001) 143-144 (2002). Among those hurt by the CMO market was Merrill Lynch, after one of its traders, Howard Rubin, lost over $337 million, in 1987, through unauthorized CMO transactions. Merrill Lynch was able to work itself out of all but $85 million of that loss. Rubin was then hired by Bear Stearns and became a star in its mortgage trading. See Cohan, supra note 25, at 209-210.

Deutsche Bank AG v. Ambac Credit Products LLC, 2006 U.S. Dist. LEXIS 45322 (S.D.N.Y. 2006). Peter Wallison, an American Enterprise Institute Fellow, gave the following description of a credit default swap where: Bank A is trying to hedge its exposure from a $10 million loan to company B “by going to C, a dealer in these swaps, who agrees to pay the $10 million to A if B defaults, in exchange for paying an annual premium to C for the protection. A will want collateral from C to be sure it’s good for the debt.” L. Gordon Crovitz, When Even Good News Worsens a Panic, Wall St. J., Nov. 24, 2008, at A17.L.

An ABX Index was created to track the value of mortgaged-backed securities based on credit default swaps.

The ABX Index is a series of credit-default swaps based on 20 bonds that consist of subprime mortgages. ABX contracts are commonly used by investors to speculate on or to hedge against the risk that the underling mortgage securities are not repaid as expected. The ABX swaps offer protection if the securities are not repaid as expected, in return for regular insurance-like premiums. A decline in the ABX Index signifies investor sentiment that subprime mortgage holders will suffer increased financial losses from those investments. Likewise, an increase in the ABX Index signifies investor sentiment looking for subprime mortgage holdings to perform better as investments.

Housing Derivatives: ABX Index, available at The CBOE also began trading credit default options in 2007 that were automatically exercised upon the occurrence of specified credit events. Press Release, Chicago Board Options Exchange, CBEO to Launch Exchange-Traded Credit Default Options in Second Quarter (Mar. 14, 2007), The Chicago Board of Trade (CBOT) also developed CDS Index Futures contracts., CBOT Credit Default Swap Index Futures Reference Guide (2008), available at

See Arthur D. Postal, Credit Default Swaps Belong Under Supervision of States, P&C Nat’l Underwriter, Feb. 23, 2009, (last visited Nov. 12, 2009).

See International Swap and Derivatives Association, Inc., Market Survey (2009), (last visited Nov. 12, 2009).

Another credit enhancement device for CDOs was the use of credit insurance written by the “monoline” insurance companies, such as MBIA Inc. and Ambac Financial Corp. Unfortunately, these insurers did not have sufficient capital to cover the losses they insured on CDOs. See Landmen Partners Inc. v. Blackstone Group, L.P., 2009 U.S. Dist. LEXIS 87001 (S.D.N.Y. 20090 (describing monoline CDO insurance).

See UBS AG, Shareholder Report on UBS’s Write-Downs § 4.22 (2008).

These risk models were created by high IQ quants, but as Warren Buffett warned, “beware of Geeks … bearing models.” Vincent Ryan, Shiller to CFOs: Quick Action Needed to Avert “D-word,”, Mar. 9, 2009, (last visited Nov. 12, 2009).

See Gillian Tett, Fool’s Gold 99-100 (2009).

See Sam Jones, Of Couples and Copulas, Fin. Times (London), Apr. 25-26, § 2, at 2.

See Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (2007).

See “Heard on the Street,” Wall St. Journal, Apr. 11, 2009, at B8.

See Tett, supra, note 48, 63-64.

See Janet Morrissey, “Credit Default Swaps: The Next Crisis,” Time, Mar. 17, 2008, available at,8599,1723152,00.html.

See Lauren Silva Laughlin, “Is the A.I.G. Rally a Little Early?” N.Y. Times, Sept. 8, 2009, at B2.

Gretchen Morgenson, “Behind Biggest Insurer’s Crisis, A Blind Eye to a Web of Risk,” N.Y. Times, Sept. 28, 2009, at A1.

Robert O’Harrow, Jr. and Brady Dennis, “Complex Deals Veiled Risk for AIG—Second of Three Parts,” L.A. Times, Jan. 1, 2009, available at Robert O’Harrow Jr. and Brady Dennis, “Credit Rating Downgrade, Real Estate Collapse Crippled AIG – 3rd of Three Parts,” Los Angeles Times, Jan. 02, 2009,

Robert O’Harrow, Jr. and Brady Dennis, “Credit Rating Downgrade, Real Estate Collapse Crippled AIG—Third of Three Parts,” L.A. Times, Jan. 2, 2009, available at

See AIG Reports Full Year and Fourth Quarter 2007 Results, Bus. Wire, Feb. 28, 2008, available at

See “AIG Reports First Quarter 2008 Results,” Business Wire, May 8, 2008, available at

See Albena Toncheva, AIG Earnings Call, Second Quarter 2008, 123 JUMP.COM, Aug. 18, 2008,,-Second-Quarter-2008/28995 (last visited Nov. 12, 2009).

David Wessel, In Fed We Trust, 194 (2009).


Id. A report by TARP Inspector General (the TARP Cop) Neil Barofsky issued in November 2009 charged that the Fed’s takeover of AIG had been badly flawed in paying Goldman Sachs and other large investment banks in full for their AIG CDS. “AIG and Systemic Risk,” Wall St. Journal, Nov. 20, at A26.

See Zachary Roth & Ben Buchwalter, The Rise and Fall of AIG’s Financial Products Unit, Talking Points Memo, Mar. 20, 2009 (last visited Nov. 12, 2009).

See David Reilly, “Wave of Write-Offs Rattles Market—Accounting Rules Blasted as Dow Falls; A $600 Billion Toll?” Wall St. Journal, Mar. 1, 2008, at A1.

It has been noted that:

The foundational ideas associated with fair value accounting were adopted by FASB in Statement of Financial Accounting Standards (FAS) 115 [in 1993]. The rule divided financial assets into three categories—those held ‘to maturity,’ those held ‘for trading purposes,’ and those ‘available for sale.’ Each of these categories is treated slightly differently. Assets held to maturity are valued at amortized cost; assets held for trading are marked to market, with unrealized gains or losses included in earnings; and assets deemed available for sale are marked to market, with unrealized gains or losses excluded from earnings but included in shareholders’ equity. Peter J. Wallison, “Fair Value Accounting: A Critique,” Fin. Servs. Outlook (Am. Enterprise Inst. for Pub. Pol’y, Washington D.C.), July 2008, at 2. That concept was further advanced with FASB’s SFAS 157, which was adopted in 2006, just as the subprime market peaked, and became effective for fiscal years beginning after November 15, 2007. SFAS 157 specified how fair value was to be reached, placing the most emphasis on the use of market prices when available. See id.


Wessel, supra note 62, at 128

Accounting Principles, 40 Sec. Reg. & L. Rep. (BNA) 1767 (2008).

Holman W. Jenkins, Jr., “Buffett’s Unmentionable Bank Solution,” Wall St. Journal, Mar. 11, 2009, at A13. As one author noted:

The argument against fair value is a compelling one: volatile markets make securities valuation difficult and undermine investors’ confidence, forcing companies to mark down values, leading to greater illiquidity and further markdowns. The more the markdowns impair capital, the greater the loss of investor confidence, and the faster the churn of the self-reinforcing cycle.

Todd Davenport. “Fair Value: Few Fans, But Fewer Alternatives; Despite Widespread Frustration, Changes Don’t Seem Likely,” 173 Am. Banker 1 (Mar. 24, 2008).

See Floyd Norris, “Volcker Criticizes Accounting Proposal,” N.Y. Times, Nov. 17, 2009, at B3.

See Floyd Norris, “S.E.C. Move May Relax Asset Rule,” N.Y. Times, Oct. 1, 2008, at C1.

This would not have been the first suspension of mark-to-market accounting during a crisis. “What many people do not realize is that mark-to-market accounting existed in the Great Depression and, according to Milton Friedman, was an important reason behind many bank failures. In 1938, Franklin Delano Roosevelt called on a commission to study the problem and the rule was finally suspended.” Brian S. Wesbury & Robert Stein, Mr. President, Suspend Mark-To-Market,, Jan. 21, 2009, (last visited Nov. 12, 2009). The Reconstruction Finance Corp. (RFC) dropped fair value accounting requirements, during the Great Depression. The RFC “deemphasized the liquidity and marketability of bank assets, and evaluated high-grade securities at their potential, not market, value. The RFC gave book or cost value to the highest grade bonds, market value for bonds in default, face value for slow but sound assets, and a reasonable valuation for doubtful assets like real estate.” James S. Olson, Saving Capitalism: The Reconstruction Finance Corporation and the New Deal, 1933-1940, 79-80 (1988).

See Kara Scannell, “Crisis on Wall Street: Mark-to-Market Likely to Remain—SEC Is Expected to Keep Accounting Rule but Seek Ways to Refine Its Use,” Wall St. Journal, Dec. 8, 2008, at C2.

SEC Office of the Chief Accountant, Division of Corporate Finance, Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting 3 (2008).

See Basel Committee on Banking Supervision, Supervisory Guidance for Assessing Banks’ Instrument Fair Value Practices, (last visited Nov. 12, 2009).

See Ruth Simon, “Study Buoys Mortgage Modification,” Wall St. Journal, Apr. 4, 2009.

See Susanne Craig & Serena Ng, “Thain’s Housecleaning Spiffs Up Merrill,” Wall St. Journal, July 2008, at C1.

See Edward M. Gramlich, Subprime Mortgages, America’s Latest Boom and Bust 65 (2007) (describing foreclosure rates for subprime mortgaged in 2002).

See UBS AG, Shareholder Report on UBS’s Write-Downs (2008).

See O’Harrow & Dennis, supra note 57.

See Press Release, American International Group, Inc., “AIG Issues Statement on Super Senior CDS Loss Risk” (Feb.12, 2008), (last visited Nov. 12, 2009)

See American International Group, Inc., Quarterly Report for the Period Ending 30 June, 2009 (Form 10-Q) 5 (2009).

Leslie Scism, “S&P Guages Bond Loss Potential on Mortgages,” Wall St. Journal, Nov. 8, 2009, at C1.

For a description of the commodity markets and futures trading see Merrill Lynch, Pierce, Fenner & Smith Inc. v. Curran, 456 U.S. 353 (2982).

Grain Futures Act of 1922, Pub. L. No. 67-331, 42 Stat. 998 (1922) (codified at 7 U.S.C. §§ 1-25). See Jerry W. Markham, The History of Commodity Futures Trading and its Regulation (1986) (describing background of this regulation) [hereinafter History of Commodity Futures Trading].

The GFA authorized the Secretary of Agriculture to designate a “board of trade” as a “contract market.” Once registered, the contract market was required to police its members’ conduct in order to prevent manipulation and dissemination of false reports that could affect commodity prices. See Grain Futures Act of 1922.

Commodity Exchange Act of 1936, Pub. L. No. 74-674, 49 Stat. 1491 (1936) (codified at 7 U.S.C. §§1 et seq.).

See History of Commodity Futures Trading, supra note 87, at 23-26.

See Jerry W. Markham, “The Manipulation of Commodity Futures Prices—The Unprosecutable Crime,” 8 Yale J. on Reg. 281 (1991).

See Jerry W. Markham & David J. Gilberg, “Stock and Commodity Options—Two Regulatory Approaches and Their Conflicts,” 47 Albany L. Rev. 741791 (1983) (describing these problems).

See Jerry W. Markham, “’Confederate Bonds,’ ‘General Custer,’ and the Regulation of Derivative Financial Instruments,” 25 Seton Hall L. Rev. 1 (1994) (describing these contracts).

See Commodity Exchange Act of 1936, Pub. L. No. 74-674, 49 Stat. 1491 (1936).

The legislation also established a Commodity Exchange Commission composed of the Secretary of Agriculture, the Secretary of Commerce and the Attorney General, that was authorized to suspend or revoke the registration of the contract market if it failed to prevent manipulative activity by its members. Id.

See History of Commodity Futures Trading, supra note 87, at 52-56.

See Commodity Futures Trading Commission Act of 1974, Pub. L. No. 93-463, 88 Stat. 1389 (1974).


See Lily Tijoe, “Credit Derivatives: Regulatory Challenges in an Exploding Industry,” 26 Ann. Rev. Banking & Fin. L. 387 (2007) (describing these jurisdictional fights, which are ongoing).

History of Commodity Futures Trading, supra, at 99-100.

Board of Trade v. Chicago Board Options Exchange, Inc., 677 F.2d 1137 (7th Cir.), vacated as moot, 459 U.S. 1026 (1982).

Futures Trading Act of 1982, Pub. L. No. 97-444, 96 Stat. 2294.

A dispute soon broke out between the SEC and CFTC over that veto power, which required another inter-agency agreement (a “Joint Policy Statement”) to settle. See Edward J. Kane, “Regulatory Structure in the Futures Markets: Jurisdictional Competition Between the SEC, the CFTC, and Other Agencies,” 4 J. Futures Markets 367, 375 (1984).

See Jerry W. Markham & Rita McCloy Stephanz, “The Stock Market Crash of 1987—The United States Looks at New Recommendations,” 76 Geo. L.J. 1993, 1999-2001 (1988).

Id. at 2001.

Government Accounting Office, “Financial Markets: Preliminary Observations on the October 1987 Crash” 63 (1988).

See U.S. Department of the Treasury, Report of the Presidential Task Force on Market Mechanisms (Jan. 8, 1988).

Id. at 61-63.

One significant development that rose from the Stock Market Crash of 1987 was the creation by President Ronald Reagan of an inter-agency task force that was to be responsible for ensuring coordination of regulation between the stock and futures markets. This group, called the President’s Working Group on Financial Markets (PWG), was composed of the heads of the Department of the Treasury, the Federal Reserve Board, the SEC and the CFTC. See Elaine S. Povich, “Trading Halts Offered as Crash Defense President’s Panel Urges No New Laws,” Chicago Tribune, May 17, 1988, at C1.

For a description of these instruments and the CFTC’s efforts to regulate them see Jerry W. Markham, “Regulation of Hybrid Instruments Under the Commodity Exchange Act—Alternatives Are Needed,” 1990 Colum. Bus. L. Rev. 1 (1990). See also Markham, supra note 93.

See Mark D. Young & William L. Stein, “Swap Transactions Under the Commodity Exchange Act: Is Congressional Action Needed?” 76 Geo. L.J. 1917 (1988).

See Regulation of Hybrid Instruments, 54 Fed. Reg. 30684, 36144 (July 21, 1989).

Futures Trading Practices Act of 1992, Pub. L. No. 102-546, 106 Stat. 3590 (1992).

See “Report of the President’s Working Group on Financial Markets, Over-the-Counter Derivatives Market and the Commodity Exchange Act (1999),” available at

Commodity Futures Modernization Act of 2000, Pub. L. No. 106-544, 114 Stat. 2763 (2000).

“The primary justifications for recommending exclusion for such transactions were a determination that most OTC financial derivatives were not susceptible to manipulation and that the counterparties in such transactions do not need the same protections as smaller, unsophisticated market participants who rely on intermediaries to conduct their transactions.” U.S. Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure 47 (2008).

See Hearing Before the CFTC to Examine Trading on Regulated Exchanges and Exempt Commercial Markets, 110th Cong. 1 (2007) (statement of Terry S. Arbit, CFTC General Counsel).

The CFTC Reauthorization Act of 2008 was enacted as Title XIII of the Food, Conservation, and Energy Act of 2008 (the “Farm Bill”). See Food, Conservation, and Energy Act of 2008, Pub. L. No. 110-246, 122 Stat. 1624 (June 18, 2008).

See International Swaps and Derivatives Association, Inc.,

See Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (2000) (describing that event).

See Ethan S. Harris. Ben Bernanke’s Fed: The Federal Reserve After Greenspan 71 (2008).

Zdenka Seiner Griswold, Counterparty Risk Management Policy Group II: OTC Documentation Practices in a Changing Risk Environment, visited at

See The Report of the CRMPG II, “Toward Greater Financial Stability: A Private Sector Perspective” (2005), available at

See Griswold, supra, note 122. (footnotes omitted). The CRMPG concluded that focusing on ten fundamental factors could anticipate financial shocks and mitigate their severity when they occur. These are:

  • Counterparty credit risk.

  • Evaporation of market liquidity.

  • Change in value of complex financial instruments.

  • Determining the value of financial instruments.

  • Use of a broad range of risk management techniques.

  • Integrity and reliability of the financial infrastructure, including effective payment and settlement systems and back office operations.

  • Valuation and stress testing of illiquid assets.

  • Allocation of adequate resources to risk management and control functions.

  • Shift from traditional restructurings to the use of credit default swaps.

  • Cooperation among industry groups, industry leaders and supervisors in the interest of financial stability.


See The Report of the CRMPG II, “Toward Greater Financial Stability: A Private Sector Perspective” (2005), available at

See Mary Williams Walsh, “Tracking Firm Says Bets Placed on Lehman Have Been Quietly Settled,” N.Y. Times, Oct. 23, 2008, at A20. (describing that resolution).

See Press Release, The Depository Trust & Clearing Corporation, DTCC Media Statement on General Motors Credit Default Swaps (June 4, 2009), available at

See “The Meltdown That Wasn’t,” Wall St. Journal, Nov. 15-16, 2008, at A10.

Christopher Cox, “Swapping Secrecy for Transparency,” N. Y. Times, Oct. 19, 2009, at WK12.

The Depository Trust & Clearing Corporation, supra note 127. “DTCC provides data, for example, on the outstanding amounts of credit default swaps on 1,000 different corporate and sovereign borrowers. “Council on Foreign Relations, Squam Lake Working Group on Financial Regulation Paper, Credit Default Swaps, Clearinghouses and Exchanges” 5 (2009). Counsel for the DTCC has also advised the author that:

DTCC Deriv/SERV LLC is a[] subsidiary of DTCC, which provides automated matching and confirmation services for OTC derivatives trades, including credit, equity and interest rate derivatives. It also provides related matching of payment flows and bilateral netting services. Deriv/SERV was established in 2003. In 2006, Deriv/SERV’s global Trade Information Warehouse was launched. The Warehouse is the market’s first and only comprehensive trade database and centralized electronic infrastructure for post-trade processing of OTC derivatives contracts over their lifecycles, from confirmation through to final settlement.

One of the many central servicing functions of the Warehouse is to calculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written. Calculated amounts are netted on a bilateral basis, and then, for firms electing to use the service, transmitted to CLS Bank (the world’s central settlement bank for foreign exchange) where they are combined with foreign exchange settlement obligations and settled on a multi-lateral net basis. Currently, all major global credit default swap dealers use CLS Bank to settle obligations under credit default swaps.

On September 1, 2009, DTCC and Markit announced the launch of MarkitSERV (, a new company that combined the two organizations’ electronic trade confirmation and workflow platforms to provide a single gateway for OTC derivative trade processing. … The partnership was first announced in July 2008, subject to regulatory filings and approval by regulators. MarkitSERV received regulatory approval from the U.K. Financial Services Authority and the U.S. Department of Justice.

Email from Scott Halvorsen, Counsel for DTCC, to the author (Sept. 22, 2009) (on file with author).

See “Central Repository Key to Reducing Systemic Risk in OTC Markets, DTCC Says,” 41 Sec. Reg. & L. Rep.(BNA) 1730 (Sept. 21, 2009).

See President’s Working Group on Financial Markets, Policy Objectives for the OTC Derivatives (2008), (last visited Nov. 12, 2009).

See Ian Talley, “Obama’s Pick for Commodity Post Vows New Era of Regulation,” Wall St. Journal, Feb. 4, 2009, at A10.

See U.S. Department of the Treasury, PWG Announces Initiatives to Strengthen OTC Derivatives Oversight and Infrastructure, Nov. 14, 2008, available at

See Securities and Exchange Commission. Temporary Exemptions for Eligible Credit Default Swaps to Facilitate Operation of Central Counterparties to Clear and Settle Credit Default Swaps, 2009 SEC LEXIS 71. Jan. 14, 2009.

See Heather Landy, “Credit Default Swaps Oversight Nears, SEC, Federal Reserve, CFTC Pledge to Work Together on Regulating Derivatives,” Wash. Post, Nov. 15, 2008.

See U.S. Department of the Treasury, Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation (2009), available at

See Stephen Luparello, Vice Chairman, Financial Industry Regulatory Authority, Statement Before the SEC/CFTC Joint Meeting on Harmonization of Regulation (Sept. 2, 2009) available at

Margin in the futures industry should not be confused with margin in the securities industry. The latter is regulated by the Federal Reserve Board under Regulation T, which generally limits the amount of loans that can be made to purchase a marginable stock to fifty percent of the value of the stock being purchased. Margin for commodities futures is not viewed to be an extension of credit, as in the case of securities. Rather, it is a good faith deposit of money, a “performance bond,” set by risk assessment systems, such as “SPAN,” to ensure that the customer will perform its obligations. See Jerry W. Markham, “Federal Regulation of Margin in the Commodity Futures Industry—History and Theory,” 64 Temple L. Rev. 59-143 (1991) (describing these differences).

See Edmund L. Andrews, “Unresolved Questions After Hearing With Geithner,” N.Y. Times, July 11, 2009, at B3.


See Zachery Kouwe, 2 “Men Accused by S.E.C. In Insider Trading Case,” N.Y. Times, May 6, 2009, at B3. Matthew Leising, Credit Swaps Investigated by U.S. Justice Department, Bloomberg, July 14, 2009. Visited at

See Matthew Leising, “Credit Swaps Investigated by U.S. Justice Department,”, July 14, 2009, (last visited Nov. 13, 2009).

See Benjamin Weiser & Ben White, “In Crisis, Prosecutors Put Aside Turf Wars,” N.Y. Times, Oct. 31, 2008, at B1.

See Mary Williams Walsh, “Insurance on Lehman Debt Is the Industry’s Next Test,” N.Y. Times, Oct. 11, 2008, at B1.

“The Moves Toward U.S. CDS Regulation,” Derivatives Wk., Oct. 20, 2008.

The issue of whether derivative instruments should be regulated as insurance was earlier considered in connection with weather derivatives. That issue was hotly debated by the NAIC Crop Insurance Committee. NAIC eventually decided that it would not treat weather derivatives as insurance because no specific property was tied to a specific casualty event in which there was an insurable interest. That same reasoning was applied to exempt CDS from insurance regulation by the New York Department of Insurance in 2000. See Futures and Options World, Storm in a Teacup (last visited Nov. 13, 2009).

See Ward S. Bondurant & Joseph T. Holahan, Regulators Take on Credit Default Swaps, (last visited Nov. 13, 2009).

By August 2008, write-offs at European banks included $44.2 billion at UBS; IKB Deutsche $12.6 billion; Royal Bank of Scotland $14.9 billion; Credit Suisse $10.5 billion; Credit Agricole $8 billion; Societe Generale $6.8 billion; Bayerische Landesbank $6.4 billion; ING Groep $5.8 billion; Lloyds TSB $5 billion; Dresdner $4.1 billion; and BNP Paribas $4 billion, to name a few. See Yalman Onaran, Banks Subprime Losses Top $500 Billion on Writedowns,, Aug. 12, 2008, (last visited Nov. 13, 2009).

See Jeremy Grant, “Watchdogs Call for Central Registry,” Fin. Times (London), Feb. 27, 2009, at 7. See also “European Central Bank, Credit Default Swaps and Counterparty Risk” (2009).

See Sebastian Hrovatin, et al., “Derivatives and the Financial Crisis,” Futures Indus. Magazine, Sept. 2009, at 43.

See The High-Level Group on Financial Supervision in the EU, The de Larosière Report, (2009), available at [hereinafter de Larosière Report].

Id. at 25.

As the European Commission’s website notes:

Currently, three committees exist at the EU level in the financial services sector, with advisory powers, the Committee of European Banking Supervisors (CEBS), the Committee of European Insurance and Occupational Pensions Committee (CEIOPS) and the Committee of European Securities Regulators (CESR). These are often known as the “Lamfalussy level 3 Committees” because of the role which they play in the EU framework for financial services legislation, created following a report by a group chaired by Alexandre Lamfalussy. European Commission, Financial Services Committee Architecture, (last visited Nov. 13, 2009).


The de Larosière Report urged that the Financial Stability Forum (“FSF”) be placed “in charge of promoting the convergence of international financial regulation to the highest level benchmarks.” de Larosière Report, supra, note 154. The FSF was an international group of regulators that was replaced by a new Financial Stability Board (FSB) by the Group of Twenty at its meeting in London on April 1, 2009. The FSB was to be expanded to include all Group of Twenty countries and the European Commission. See Financial Stability Board, History (last visited Nov. 13, 2009).

See“Commission for the European Communities, A Proposal for the Regulation of the Eurpoean Parliament and of the Council” (2009), available at

See the de Larosière Report, supra note 154, at 25.

Id. The de Larosière Report calls for actions to reduce pro-cyclicality by moving away from short-term VaR models and raising minimum capital requirements. Id. at 17-18.

See Huw Jones, EU Regulators Plan CDS Warehouse in Europe, Reuters, Feb. 27, 2009, available at

See “Commission of the European Communities, Communication from the Commission: Ensuring Efficient, Safe and Sound Derivatives Markets” (2009) available at

Id. at 9.



Id. The European Commission recognized that this may be difficult due to some commercial advantages to bilateral clearing but hopes it can overcome commercial hesitation to taking up CCP clearing by amending the rules on regulatory capital contained in Capital Requirements Directive. Id. at 10-11. The Commission also recognized that not all CDSs could be standardized and that the bilateral clearing model must be strengthened for those contracts to accomplish the following: (1) improve timeliness of marking to market valuation (ideally daily); (2) improve collateral coverage rate; (3) strengthen collateral management by promoting more frequent reconciliation and timely exchange of collateral; and (4) “Reduce the size of outstanding derivatives positions and facilitate the management of a potential default by promoting increased recourse to multilateral portfolio compression (i.e., multilateral netting of positions)”. Commission Staff, Consultation Document: Possible Initiatives to Enhance the Resilience of OTC Derivatives Markets (Commission of the European Communities, Working Paper SEC(2009) 914 final, 2009), available at

See The European Association of Corporate Treasurers, Comments in Response to Consultation Document: Possible Initiatives to Enhance the Resilience of OTC Derivatives Markets (July 3, 2009), available at

Id. at 4.

G-20, Leaders’ Statement: Pittsburgh Summit 2009 9 (Sept. 24-25, 2009) available at

Id. at 3.

Id. at 9. EU Internal Market Commissioner Charlie McCreevy stated in October 2009 that the EU and the United States had reached a consensus on the following points:

standardized over-the-counter products should be cleared as far as possible by central clearing houses; Central data repositories should enable supervisors to get a complete overview of where the risks are in the system; and bilateral clearing should be tightened and made more secure for those segments of the market that may not fit central counterparty clearing.

Eurpoean Union, “U.S. Downplay Differences Over Regulatory Approach to Derivatives,” 41 Sec. Reg. & L. Rep.(BNA) 1821 (Oct. 5, 2009).

Financial Services Authority, The Turner Review: A Regulatory Response to the Global Banking Crisis 82 (2009), available at [hereinafter Turner Review]. The FSA is also taking a more aggressive approach to dealings in CDS, including references to the Serious Fraud Office. Harry Wilson, “FSA Looks Into Trading in Penrod Credit Default Swaps,” DowJones Online, Aug. 24, 2009, available at


See “Financial Services Authority, A Regulatory Response to the Global Banking Crisis” (Mar. 2009) (Discussion Paper 09/02), available at

Id. The Turner Review Discussion Paper also notes that the FSA has made good progress on some other operational objectives, “such as the scheduled incorporation of a cash settlement process for CDS into standard documentation. These include the establishment of new targets including T+0 submission of eligible CDS trades, electronic matching and the increased use of compression services (which terminated $27 trillion of contracts in 2008) and the development of ‘roadmaps’ for similar operational improvements for all major OTC derivative asset classes and for collateral management practices.” Id.

See “HM Treasury, Reforming Financial Markets” (July 2009), available at


Id. at 81.


For a description of FIEL see Japan Financial Services Authority, “New Legislative Framework for Investor Protection,” available at

Id. at 10, 19, 21.

Tetsuya Itoh, “Pay Careful Attention,” 2007 Int’l Fin. L. Rev. 67-69 (2007) (supp. to the 2007 Global Report, Oct. 1, 2007), available at

FIEL had been under discussion for years, and the nature and scope of the subprime crisis was largely unforeseen at the time FIEL was enacted. Even a subsequent amendment to the FIEL promulgated on June 13, 2008, did not seem to adopt any measures related to regulation of financial derivatives. See Japan Financial Services Authority, “Outline of the Bill for Amendment of the Financial Instruments and Exchange Act, Etc.,” available at

Tokyo Financial Exchange, “Study Committee on Central Counterparty for OTC Derivatives Transactions” (Apr. 2009), available at

Id. at 3.



Id. at 5.

Id. at 6.

Id. at 8.

Id. at 7.

This effort was co-chaired by the Autorité des Marchés Financiers (AMF) of France and the Australian Securities and Investments Commission (ASIC). See “International Organization of Securities Commissions, Unregulated Financial Markets and Products—Final Report” (Sept. 2009), available at

G-20 Communiqué Declaration on the Summit of Financial Markets and the World Economy (Nov, 15, 2008), available at

Id. at 29.

UBS AG, Shareholder Report on UBS’s Write-Downs § 4.2.3 (2008).

See Merrill Lynch, 2008 Annual Report (Form 10-K) 27 (2008).

Kenneth C. Johnston, et al., “The Subprime Morass: Past Present and Future,” 12 N.C. Bank. Inst. 125, 135 (2008).

See Citigroup, Inc., 2008 Annual Report (Form 10-K) 18 (2008).

See notes 55-61 and accompanying text.

Their rate of return did encourage carry trades, but at low returns. UBS AG, Shareholder Report on UBS’s Write-Downs § 4.2.3 (2008).

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