Risk Management

New York: Credit-Default Swaps=Insurance

The state will regulate a chunk of the derivatives as insurance, requiring issuers to put up reserves and be licensed as insurers.
Stephen TaubSeptember 22, 2008

Beginning in January, New York will regulate part of the previously unregulated credit-default-swap market, the state’s governor, David Paterson, announced today. The faulty use of the swaps has been heavily blamed for the current Wall Street credit crisis.

Gov. Paterson also called on the federal government to regulate the rest of the $62 trillion market. Counterparties of credit-default swaps—thought to be a cousin of short selling—profit when the value of bonds go down.

Under Paterson’s direction, the New York Insurance Department issued new guidelines establishing that some credit swaps are insurance and can thus be overseen by the department. “The absence of regulatory oversight is the principle cause of the Wall Street meltdown we are currently witnessing,” Paterson said. “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.”

Eric Dinallo, the New York State Insurance Superintendent who played a role in putting together last week’s bailout of American International Group, said that the “severity of this crisis was substantially increased by what the government chose not to regulate, principally credit default swaps.” “The current problems in the financial markets are “a credit crisis, not an equity crisis, and that is where the focus should be now. What New York State is doing fits our role as insurance regulators.” he said.

Patterson said in a press release that the goal of regulating credit-default swaps is to ensure that sellers have enough capital and adequate risk management policies in place to protect the buyers, who are, in effect, policyholders.

The governor noted that AIG’s insurance operations and other insurance companies regulated by the state are required to hold substantial reserves, and, as a result, they’re solvent and able to pay claims. But a major part of AIG’s problems were spawned by the issuance of credit-default swaps by AIG Financial Products, a non-insurance unit that did not hold enough reserves, according to Paterson.

The governor asserted that 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 can’t, for example, pay principle or interest of a bond held by the buyer. In those cases, the swap is insurance, because the swap buyer is like a homeowner insuring a home.

New York’s new guidelines establish that when the buyer owns the underlying security on which he is buying protection the swap is an insurance contract. Under the new rules, such swaps can only be issued by entities licensed to conduct insurance business. The new guidelines will not take effect until January 1.