NEW YORK–In a move toward developing a comprehensive credit default swap policy, a group of the nation's state legislators took testimony from experts, who urged putting swaps under state insurance regulators' control.

Among those who testified here Saturday at the National Conference of Insurance Legislators' hearing on credit default swap market regulation was Michael Greenberger, a University of Maryland School of Law professor, who said there is an acute need for better oversight and urged state lawmakers to take the lead on the issue.

Do not wait for the federal government to take action, he advised the NCOIL panel.

NCOIL, under its financial services and investment products committee steered by New York Assemblyman Joseph Morelle, D-Rochester, is due to discuss whether to pursue model legislation during its spring meeting next month in Washington.

Mr. Greenberger reiterated comments of earlier speakers that no one really has a full handle on the total CDS market, which has caused major investment losses, and that the conventional wisdom in Washington is that insurance regulation has failed.

He said that failure to take the lead on the issue is inviting a notion that “states are just not up to this responsibility.” This notion is “not only about credit default swaps but the ability to regulate all insurance regulation.” He urged state legislators to “aggressively” take up the issue.

And, he said that he was “very, very worried that we are not near the tip of the iceberg” because of other CDS backed not by residential mortgages but commercial mortgages, credit card debt, and auto and student loans.

Eric Dinallo, New York superintendent of insurance, explained the CDS market to legislators and said it really needs to be differentiated between covered and naked commercial default swaps and that the approach legislators and regulators take should be different depending on the type of security.

A covered CDS occurs when you actually have risk and you want to transfer that downside risk, while the purchaser of a naked CDS does not have any risk but is taking a bet that the company in question and its security will falter, according to Mr. Dinallo.

Mr. Dinallo said that a CDS is, at the base, a security, and not insurance, because the party accepting risk offers no guarantee to make an affected party whole, as there would be in an insurance arrangement.

CDS is at the base, a security and not insurance because there is not a guarantee to make a party whole as there is in insurance, he said.

Mr. Dinallo and his department maintain that covered CDS, which it estimates make up about 20 percent of the market, are insurance products.

The lack of transparency was a disturbing point that came to light as the New York Insurance Department worked on the federal government's seizure of American International Group, New York, Mr. Dinallo told the lawmakers. While AIG held approximately $450 billion in CDS, “we can't say how much was written on AIG. Nowhere was it listed where we could get a sense of it.”

Mr. Dinallo said that all CDS should be listed on an exchange in order to increase transparency.

Robert Pickel, executive director and chief executive officer of the International Swaps and Derivatives Association, New York, noted that CDS can and have brought a “tremendous amount of value to the economy” and have “transformed the credit business.”

Requiring collateral can be a “very powerful tool,” according to Mr. Pickel. And, Mr. Pickel said, insurance regulators need full information available both on regulated and unregulated parts of a company so there will be a fuller picture of what the company's holdings are.

Michael Schozer, president of Assured Guaranty and director of the Association of Financial Guaranty Insurers, both in New York, explained that CDS are similar to letters of credit and that LOCs are not insurance. And, he added, it is important to distinguish between CDS and liquidity issues.

What he suggested to NCOIL legislators as a better approach is a proper measurement of imbedded liquidity risk, not tying posting of collateral to rating triggers and mark-to-market accounting, which forced the sale of securities in a falling market.

Another action item Mr. Schozer recommended was increased regulation of rating agencies because $225 billion in “AAA”-rated CDS defaulted.

Others offering testimony that CDS should definitely be regulated by disinterested parties included Ryan Wilson, a senior policy advisor with AARP Public Policy Institute, Washington, and David Ingram, a senior vice president of Willis Re, speaking on behalf of the American Academy of Actuaries, Washington.

Thomas Hoens, a partner with HRF Associates, Westfield, N.J., said that “without question,” NCOIL should start the process of regulating CDS.

“To the extent that [state legislators] wait, it is a possible open door to federal regulation of insurance,” Mr. Hoens warned NCOIL legislators. He said that CDS are insurance products and he “would like to see states retake control of this industry.”

Insurers are “sound and solvent” and did not cause the need for a bailout, according to Nat Shapo, who was representing the National Association of Mutual Insurance Companies, Indianapolis. He said that CDS should receive congressional oversight but not disturb a regulatory system that works well.

NCOIL President and New York Sen. James Seward, R-Oneonta, said in a statement after the session that the message from experts “was loud and clear: that unfettered, 'naked' swapping should not be allowed. Participants in the CDS market are not subject to the same strong solvency, reserving and insurable interest standards that are imposed on actors operating in the insurance market.”

“These standards protected the insurance sector as other financial services industries have struggled or failed during this economic crisis. NCOIL legislators at the hearing found the definite need to fill an existing regulatory gap and to provide guidance to the states on how to address CDS regulation.”

Special Reports /

NCOIL Takes Up Swaps Regulation

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