New York Insurance Superintendent Eric Dinallo echoed an earlier pledge during a Senate hearing last week to regulate part of the credit default swap market, while endorsing a more “holistic” approach to the investment option that nearly brought the economy to its knees.

Appearing before the Senate Agriculture Committee, Mr. Dinallo explained that credit default swaps can be divided into two categories.

o 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.

o 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 it is effectively a “directional bet,” he said.

Such swaps, he explained when announcing new state regulations last month, are comparable to the short-selling of stocks, because they are used by speculators who do not own the bonds.

On Sept. 21, New York Gov. David Paterson and Superintendent Dinallo announced that since credit default swaps under the first definition qualify as insurance, they will therefore be regulated beginning on Jan. 1, 2009.

The new guidelines, outlined in a circular letter from the state's insurance department, will not affect any existing credit default swaps, but instead provide a means for current and new companies to more prudently provide this type of insurance, the department said.

In the statement, Gov. Paterson said the federal government should regulate the remainder of the credit default swap market, noting that it played a major role in the problems at American International Group, Bear Stearns and bond insurance companies.

Indeed, credit default swaps on CDOs are “the source of a large part of AIG's financial troubles,” the announcement of the guidelines noted.

AIG has required two federal loans totaling over $120 billion to stabilize the company following financial difficulties at its financial products company related to the issuance of credit default swaps.

Two crucial developments contributing to the increase in credit default swaps took place in 2000, Mr. Dinallo noted during last week's hearing, with the first being 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, while also exempting them from regulation by the federal Commodity Futures Trading Commission.

During the same year, Mr. Dinallo noted that the New York department, under the prior Republican 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.”

However, he added, “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.

Contending that such swaps were designed not to fall under insurance or futures regulation, Sen. Tom Harkin, D-Iowa, the committee chairman, said “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 overly 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 regain control 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 credit default swaps are conducted responsibly is to make certain 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.

Earlier this month, Mr. Dinallo told a congressional oversight hearing it “would be a broad misunderstanding, bordering on inappropriate” to view AIG's liquidity problems as an argument for federal regulation.

Mr. Dinallo told the House Committee on Oversight and Government Reform that “it is important to have the states in the [insurer] solvency business,” because while the states have been “clunky” on other issues, they've done very well on solvency.

Mr. Dinallo also urged federal lawmakers to “revisit” the Gramm-Leach-Bliley Act, passed in 1999 to succeed the Glass-Steagall Act, bringing down barriers separating different types of financial entities. “The 'supermarket of financial services' that law created can cause problems for the whole economy 'when something smells in aisle six,'” he said.

Special Reports /

Credit Default Swaps Dissected

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