WASHINGTON–New York State Superintendent of Insurance Eric Dinallo echoed an offer by New York Gov. David Paterson's to regulate part of the credit default swap market at a Senate hearing today, but also endorsed a more “holistic” approach to the problem.

Appearing before the Senate Agriculture Committee, Mr. Dinallo explained that credit default swaps can be divided into two categories. The first he noted are transactions in which the holder of an obligation, such as a bond, “swaps” the risk of default with another party, who guarantees it for a fee. That transaction, he noted, can be seen as similar in nature to an insurance transaction.

A second form, which Mr. Dinallo referred to as a “naked credit default swap” differs in that no party involved has ownership of the obligation, and is effectively a “directional bet,” he said.

Two crucial developments contributing to the increase in credit default swaps took place in 2000, Mr. Dinallo said. The first was the enactment of the Commodity Futures Modernization Act under President Bill Clinton.

That law, he said, created a “safe harbor” for credit default swaps by preempting state laws that would have barred them and exempting them from regulation under the Commodity Futures Trading Commission.

During the same year, Mr. Dinallo noted that the New York Department of insurance, under a different administration, was asked what he called a “very carefully crafted question,” inquiring if naked credit default swaps were considered insurance contracts.

“Clearly, the question was framed to ask only about naked credit default swaps with no proof of loss,” he said. “Under the facts we were given, the swap was not 'a contract of insurance' because the buyer had no material interest and the filing of a claim does not require a loss.

“But the entities involved were careful not to ask about covered credit default swaps. Nonetheless, the market took the department's opinion on a subset of credit default swaps as a ruling on all swaps and, to be fair, the department did nothing to the contrary.”

Because of these developments, witnesses and committee members noted, credit default swaps were allowed to go unregulated. Noting that such swaps were designed not to fall under insurance or futures regulation, Sen. Tom Harkin, D-Iowa, the committee chairman noted “they need not be traded on open, transparent exchanges, and as a result, it is literally impossible to know whether swaps are being traded at fair value or whether institutions trading them are becoming over leveraged or dangerously overextended.”

The option of creating an exchange for credit default swaps, or another mechanism such as a clearinghouse of central counterparties, were depicted as potential solutions to help get hold of a market that Sen. Harkin said grew to an estimated $62 trillion in face value last year. “That roughly equals the gross domestic product of the entire world for 2008,” he noted.

While implementing some form of regulatory scheme was discussed, witnesses cautioned against extreme measures such as an outright ban on “naked” swaps, insisting there are legitimate reasons to engage in such transactions.

Richard Lindsey, president of the New York-based Callcott Group, countered Sen. Harkin's characterization of swaps as “casino capitalism” by noting that they are not entirely dissimilar to futures or other investments. “While credit derivatives are often pejoratively described in the media as a 'bet,' it is important to realize that one could equally describe all investments as 'bets,'” he said.

Mr. Dinallo added that “naked” swaps can also help companies hedge against exposures that are not directly related to them. As an example, he noted that a company may seek protection through a credit default swap if they have a large number of receivables from another entity, and are exposed to a possible downturn in that entity's ability to deliver.

Ultimately, Mr. Lindsey proposed that the best solution for ensuring that credit default swaps are conducted responsibly is to make sure those executives whose companies are involved know exactly what they are undertaking.

“It is not sufficient to receive assurances that everything is well controlled. Each individual has a duty to probe, to challenge and to ensure that he or she has confidence in and understands the answers,” he said.

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Dinallo Outlines Credit Swap Status To Senate

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