Credit Derivative Destruction and Mortgage-Backed Mayhem: The End of an Era of Deregulation

Matt S. Klapper, Boston University School of Law

Abstract

Abstract: The absence of regulation in mortgage-backed securities and over-the-counter credit derivatives markets was instrumental in fomenting the worst financial crisis since the Great Depression—referred to in this paper as the Great Panic. The antecedents of the Great Panic of 2008 are numerous. Rather than provide an exhaustive compendium of the causes of the Great Panic, the primary focus of this essay is on mortgage-backed securities, credit derivatives and the absence of regulatory oversight. This paper argues for greater transparency in these opaque securities markets as a means of reducing systemic risk and improving regulatory oversight. Mortgage-backed securities (MBS), particularly collateralized debt obligations, facilitated both the extension of credit to unworthy borrowers and increased the likelihood of default—a dangerous combination involving the centerpiece of the American Dream. MBS became toxic when real estate prices in the United States declined and mortgage defaults increased dramatically. Credit default swaps (CDS), a financial instrument few on or off Wall Street had much familiarity with prior to the crisis, would suddenly loom large in the public eye at the outset of the Great Panic as systemic risk stemming from huge sell-side losses in CDS markets resulted in massive losses all across Wall Street. Over the past decade, financial institutions like AIG, Citibank, Merrill Lynch and Morgan Stanley had collected millions of dollars in premiums from sell-side CDS positions, were now on the hook for billions in losses. The evisceration of wealth during the Great Panic provided a painful end to the Era of Deregulation, and hopefully taught an important lesson. With the passage of the Dodd-Frank financial reform bill, this author believes that the injection of transparency and capital requirements into CDS and MBS markets will ensure that systemic risk is effectively contained going forward.