New Guidance for Credit Default Swaps in New York

New Guidance for Credit Default Swaps in New York

Yesterday, the New York State Insurance Department issued Circular Letter No. 19 (2008) primarily to address the behavior of financial guarantee insurers involved in credit default swaps.

Readers may access a copy of Circular Letter No. 19 here.

In a press release issued Sept. 22, Governor David A. Paterson announced that New York State will—beginning in January—regulate part of the credit default swap market which has to date been unregulated and has been a major contributor to the emerging financial crisis on Wall Street. Governor Paterson also called on the federal government to regulate the rest of the massive $62 trillion market.

A seller of a credit default swap promises to pay the buyer if the insurance provider of a bond cannot pay the principal and interest on the bond. If the owner of a bond buys the credit default swap, then it is like insurance. Using this theory like a neat stack of Legos®, the Insurance Department determined that credit default swaps are within its purview: if a buyer owns the bond on which it buys the credit default swap, then it is insurance and the Insurance Department can regulate it. Swaps bought by speculators are still unregulated by the State.

At this point, Circular Letter No. 19 sets out best practices for financial guarantee insurers (also called bond insurance companies or monolines). These don't go into effect until January 1, 2009 – giving everyone time to figure out how to play nice. The Insurance Department plans to propose both regulations and legislation to continue the reforms.

The new best practices will:
1. limit financial guarantee insurers from guaranteeing collateralized debt obligations (CDOs) based on payments  from many mortgages
2. limit risks for financial guarantee insurers
3. require written risk and underwriting policies
4. increase capital and reserve requirements
5. expand reporting requirements

As time goes on, it looks like the new insurance playground is going to have even more rules imposed upon it, but that seems to be necessary to make sure that there are fewer bloody noses.