Current Developments in State and Federal Regulation of Swaps and Derivatives

Current Developments in State and Federal Regulation of Swaps and Derivatives


Recent pronouncements from the New York Insurance Department and the Missouri Insurance Department have concluded that some credit derivatives are "insurance" and are to be regulated as such. In this Commentary, James Gkonos and Mark Cawley explore recent proposals to exert regulatory authority over the largely unregulated credit default swap market by the New York Insurance Department and the federal government. They write:
 
     The financial meltdown that began in August, 2008 and that has plunged the U.S. and the world into recession is directly traceable to the intersection of the U.S. housing market bubble and innovative financial products known generally as collateralized debt obligations (CDOs) and credit default swaps (CDSs). The housing bubble began in the late 1990s as housing prices began to spike upward deviating from historical rates of increase. The rapid increase in home prices was supported in part by mortgage lending to so-called subprime borrowers who either had less than perfect credit or who had good credit but borrowed more than their income and assets might otherwise allow. Subprime lending, in turn, was made increasingly possible by the use of innovative--and risky--mortgage products like adjustable rate mortgages and by the advent of the mortgage backed security (MBS), a form of CDO.
 
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    Following the collapse of Lehman Brothers, the near-collapse of AIG as a result of their exposure to CDSs, and the financial distress of the majority of monoline insurers, the New York Insurance Department decided to revisit the issue of the regulation of these financial products. In a September 22, 2008 Circular Letter, the New York Department of Insurance announced that, beginning in January, 2009, it would regulate covered CDSs, which it defined as CDSs where the protection buyer holds, or reasonably expects to hold, a material interest in the reference entity or obligation. Consistent with its role as insurance regulator, New York intended to provide an appropriate way for those with an insurable interest to protect themselves and [the Department will] ensure that whoever sells them that protection is solvent.
 
(footnotes omitted)