N.Y. Exchange Might Facilitate Credit Default Swaps!

During his visit this afternoon to NU's editorial headquarters here in Hoboken, New York Insurance Superintendent Eric Dinallo raised an interesting possibility to help fuel a reborn Insurance Exchange in the Empire State--the trading of credit default swaps, which is not as crazy as it might sound at first blush!

Before you push the panic button, given the fact that CDS dabbling nearly destroyed American International Group (and threatened to take the entire economy down with them), when you think about it, the idea makes a lot of sense.

"Theoretically, the New York Insurance Exchange would be a perfect place to clear credit default swaps," Mr. Dinallo said during a 90-minute exclusive Q&A with NU's editorial staff. "The exchange offers the transparency that's been lacking up until now, and could qualify these trades as insurance, which is what they should have been considered all along, because they promise a guaranteed payment."

The problem with credit default swaps, he argued, is that they were treated as an investment, which very well could (and did) end up with zero value. "That is not an option in an insurance product, which guarantees payment if the covered contingency occurs," and therefore is subject to capital standards and tight solvency oversight.

While credit default swaps got a bad name after AIG's misadventures and the economic meltdown that resulted, Mr. Dinallo thinks that with the proper transparency and oversight, they remain useful financial risk management tools.

"I never said credit default swaps are evil, even naked swaps," he noted, referring to sales to those who do not even own the CDOs being hedged. "It's just that they've been mischaracterized as an investment product, when in fact they were sold to function more like insurance," even though they could not be regulated by state insurance departments.

As a result, he told NU, "those buying CDS thought they had turned lead into gold," when in fact the expectation of a financial guarantee could not be fulfilled. He suggested such problems could be rectified within a more tightly regulated and far more transparent New York Insurance Exchange.

Last month, Mr. Dinallo put out a call for industry comment on the idea of resurrecting the exchange, which I noted in a recent blog--and the superintendent said he is receiving a lot of feedback, particularly from brokers seeing more placement options in a hardening market.

"We want to see if there is economic demand before proceeding," he reiterated, emphasizing that he still sees the exchange as "a great opportunity for one-stop shopping."

He also thinks having a syndicated market in New York will put the heat on Bermuda, which, he said, is "being looked at a little more skeptically these days, with buyers seeking a more robust regulatory regime."

He argues that "if the tax disparity is removed somehow" by Congress at the urging of a number of heavyweight onshore players, "Bermuda will look a lot less attractive."

Mr. Dinallo also held out the possibility of providing a tax advantage of some sort for doing business in a renewed insurance exchange in the state--"not to make it tax-free, but at least kind of neutral against Bermuda. We'd bring in more capital to the state and more insurance business."

The superintendent is not discouraged by the fact that potential sources of capital to fuel a new exchange have dried up. "A lot of hedge fund capital has gone away, but not permanently," he said. "There are still lots of private equity investors seeking uncorrelated risks to invest in, which an insurance exchange could provide."

As the market hardening picks up steam this year, an insurance exchange could make a lot of sense. Whether the facility can raise enough capital remains to be seen, but it's a worthy effort, in my view.

What do you folks think?