New York to Begin Regulating Part of Credit Default Swap Market

September 23, 2008

New York Governor David A. Paterson said that New York State will, beginning in January, regulate part of the credit default swap market which has to date been unregulated and has been a major contributor to the emerging financial crisis on Wall Street.

Paterson also called on the federal government to regulate the rest of the massive $62 trillion market.

This action is similar to one recently taken by the federal government that tightly restricts “short selling,” or profiting from falling stock prices. The state action applies to credit default swaps which are a means of profiting from falling values of bonds.

The New York Insurance Department issued new guidelines that, for the first time, establish that some credit swaps are insurance and therefore subject to state regulation.

“The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing. While I applaud the recent federal intervention to stabilize the market – and thus our entire
economy – it is important we also take the next step as a nation by regulating areas of the market which have previously lacked appropriate oversight,” said Paterson.

Earlier this year, New York was the first state in the nation to mandate certain regulatory control of the subprime lending market.

Paterson urged the federal government to regulate the rest of the credit default swap market, which, he said, “will have a positive impact on our collective efforts to get the national economy back on track.”

Eric Dinallo, New York State Insurance Superintendent, said that the severity of the current crisis that led to problems at American International Group, Bear Stearns and other firms “was substantially increased by what the government chose not to regulate, principally credit default swaps.”

“This is primarily a credit crisis, not an equity crisis, and that is where the focus should be now,” Dinallo said.

He said that what New York State is doing is approrpiate in its role as insurance regulator. “We are providing an appropriate way for those with an insurable interest to protect themselves and we are going to ensure that whoever sells them that protection is solvent, in other words, can actually pay the claims. There is currently no such protection for policyholders. However, we are not regulating naked credit default swaps.”

The goal of regulating these swaps is not to stop sensible economic transactions, but to ensure that sellers have sufficient capital and risk
management policies in place to protect the buyers, who are in effect policyholders, according to Dinallo.

At AIG, for example, insurance companies regulated by the state are required to hold substantial reserves and as a result those
companies are solvent and able to pay claims. However, a major part of AIG’s problems were created when credit default swaps were issued by a non-insurance unit that did not hold sufficient reserves.

A credit default swap is similar to a short sale of a stock. In both cases, an investor profits when the value of the security, either a bond or a stock, declines. As part of efforts to contain the current financial crisis, the federal government has temporarily limited some short sales of some stock to prevent destructive speculation that was damaging the health of targeted companies.

Credit default swaps played a major role in the financial problems at AIG, Bear Stearns and the bond insurance companies. A credit default swap is a contract under which the seller promises to pay the buyer if the insurance provider of the bond cannot pay principal and interest. Credit default swaps can be used by the owners of bonds who want to protect themselves if the company that issued the bonds is unable to pay interest and principal. In those cases, the swap is insurance, because the swap buyer is like a homeowner insuring a home.

But, just as with short selling of stock, most swaps are now used by
speculators who do not own the bonds and the value of swaps outstanding are generally much more than the value of a company’s debt. Swaps bought by speculators are known as “naked swaps” because the swap purchasers do not own the underlying bond. Speculation in a company’s bonds can under some circumstances hurt that company’s ability to borrow.

New York’s new guidelines establish that when the buyer owns the underlying security on which he is buying protection then the swap is an insurance contract. Under these new regulations, such swaps would be subject to regulation for the first time and can thus only be issued by entities licensed to conduct insurance business. So called “naked swaps” are not insurance and cannot be regulated by the state, according to Dinallo.

The department issued Circular Letter No. 19 (2008), which sets forth best practices for financial guarantee insurers, also known as bond insurance companies or monolines.

The new best practices:

1. Strictly limit financial guarantee insurers from guaranteeing collateralized debt obligations or “CDOs”—securities based on the payments from many mortgages. These CDOs, often based on subprime mortgages, have caused substantial financial difficulties for many commercial and investment banks. Credit default swaps on CDOs are the source of a large part of AIG’s financial troubles.

2. Institute a number of measures to limit risks for financial guarantee insurers. For example, the rules better define concentration risk, which is the risk from insuring too many bonds from a single source. The new rules include originators and servicers of debt as sources to consider.

3. Require written risk control and underwriting policies.

4. Increase the minimum amount of capital and reserves a financial guarantee insurer must maintain.

5. Expand reporting requirements.

Dinallo said he also plans to propose regulations and legislation to implement reforms.

The new guidelines will not affect any existing credit default swaps. Financial guarantee companies were very active in selling credit default swaps, but are conducting little if any business currently. The new guidelines are meant to provide a means for current and new companies to more prudently provide this type of insurance.
To avoid market disruptions, the guidelines on credit default swaps will not take effect until Jan. 1, 2009.

In 2000, the department ruled that all credit default swaps were not insurance. This new regulatory policy and circular letter reverse that decision only to the extent that certain swaps are insurance under New York Insurance Law.

Source: NYSID

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