New York State officials announced yesterday that some credit default swaps qualify as insurance, thus they will regulate those financial instruments beginning Jan. 1, 2009.
The announcement came from Gov. David A. Paterson and Insurance Superintendent Eric Dinallo.
New York's action by its Democratic executive branch is a reversal of policy. In 2000, when the insurance department was in the hands of Republicans, it ruled that all credit default swaps were not insurance.
In their statement, Gov. Paterson said the federal government should regulate the remainder of the credit default swap market, noting that they played a major role in the problems at American International Group, Bear Stearns and bond insurance companies.
A credit default swap was defined as a contract under which the seller promises to pay the buyer if the insurance provider of a bond cannot pay principal and interest.
New York officials said that in such cases the swap is insurance, because the swap buyer is akin to a homeowner buying protection for risks to a home.
However, most swaps, they added, are comparable to short-selling of stocks, because they are used by speculators who do not own the bonds, and the value of swaps outstanding are generally more than the value of a company's debt.
The new January guidelines establish that when the buyer owns the underlying security on which they are buying protection, then the swap is an insurance contract, and can only be issued by licensed insurance entities.
Those cases where swap purchasers do not own the underlying bond–so-called "naked swaps"–are not subject to the regulation.
The new guidelines, outlined in a circular letter from the state's insurance department, will strictly limit financial guarantee insurers from guaranteeing collateralized debt obligation securities based on the payments from many mortgages.
CDOs, it was noted, are often based on subprime mortgages that have caused substantial financial difficulties for commercial and investment banks. Indeed, credit default swaps on CDOs are "the source of a large part of AIG's financial troubles," the announcement of the guidelines noted.
The new rules also have a more specific definition of "concentration risk"–the risk from insuring too many bonds from a single source. The new rules include originators and servicers of debt as sources to consider.
Also included are requirements for written risk control and underwriting policies, as well as increases in the minimum amount of capital and reserves a financial guarantee insurer must maintain.
Additionally, reporting requirements are expanded.
Circular letters provide regulated insurance companies with direction from the insurance department, which said it also plans to propose regulations and legislation to implement reforms.
The department said it is prepared to answer questions and provide guidance about its views with regard to complicated credit default swap issues.
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 guideline provides a means for current and new companies to more prudently provide this type of insurance, the department said.
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