Credit-Default Swaps Move Closer to Regulation With N.Y. Plan

New York State's proposal to start regulating part of the credit-default swaps market may accelerate oversight of an industry blamed for helping to almost bring down the U.S. financial system.

New York Governor David Paterson said in a statement yesterday that the state will consider contracts sold to investors who own bonds they are trying to protect from default as insurance. The plan won't apply to contracts purchased by speculators who only want to bet on an increase or decrease in a borrower's creditworthiness and don't own bonds.

Calls for greater regulation of the $62 trillion market have grown after the U.S. had to take over American International Group Inc. and provide the New York-based insurer with an $85 billion loan to cover obligations at a unit that sold protection on securities through the credit-default swap market. The AIG subsidiary was required to post collateral against more than $400 billion of contracts after its credit rating was downgraded.

``I think it's clear to everyone that there's going to be more regulation coming'' said Brad Golding, managing director at Christofferson Robb & Co., New York-based money management firm. ``Is every swap dealer in the world going to have to apply to New York for an insurance license? The bottom line is: good luck with that.''

Claims Paying Ability

Under Paterson's plan, the New York State Insurance Department would require entities selling credit-default swaps to bondholders to show they can actually pay the claims if there is a default. The new guidelines will become effective in January.

``The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing,'' Paterson said. ``I urge the federal government to follow New York's lead once again by regulating the rest of the credit- default swap market.''

Credit-default swaps, which are traded between banks, hedge funds, insurers and other investors, are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt or to hedge against losses.

They pay the buyer face value in exchange for the underlying securities or the cash equivalent should the borrower fail to adhere to its debt agreements. The market has grown 100-fold over the past seven years to cover $62 trillion of debt, or more bonds than there are outstanding.

Market Disruption

New York regulators threaten ``to disrupt global derivatives markets'' through this action, said Robert Pickel, chief executive officer of the International Swaps and Derivatives Association. The New York-based industry group represents dealers and investors, and sets standards for trading.

``The state of New York should proceed very cautiously and in consultation with federal regulators before acting in a way that may ultimately cause more harm than good,'' Pickel said in a statement.

Until now, the state hasn't regulated the credit-default swap market even as bond insurance companies expanded into the business of guaranteeing securities through contracts rather than insurance policies.

Five of seven formerly AAA rated bond insurers, including Armonk, New York-based MBIA Inc. and Ambac Financial Group Inc. in New York, lost their top rankings after writing credit-default swap contracts on more than $100 billion of so-called collateralized debt obligations backed by subprime mortgages.

`Further Dislocation'

Insurance companies, which are prohibited from entering into derivative transactions directly, created special purpose vehicles to create credit-default swaps they could sell to investors. These SPVs were minimally capitalized because their obligations in the event of a security defaulting were guaranteed by the insurance company.

``We are concerned that this plan has not been well thought through,'' Tim Backshall, chief strategist at Credit Derivatives Research LLC, said in a note to clients about the New York state plan yesterday. ``These ad hoc actions are more likely to cause further dislocation than help any realignment and normalcy.''

Until New York State Insurance Department Chairman Eric Dinallo provides more details about the plan, the effort may obscure rather than clarify some of the regulatory obstacles, said Ed Grebeck, chief executive officer of Tempus Advisors, a debt consulting firm in Stamford, Connecticut.

``How is Dinallo going to say who is adequately capitalized?'' Grebeck said. ``I don't think this thing is clearly thought out. Parties buying protection in the credit default swap market are all international investors. I don't see how New York State can address what is an international issue.''

The Federal Reserve Bank of New York has been the most involved in trying to reduce risks in the credit swaps market, starting with demands in 2005 from New York Fed President Timothy Geithner that banks reduce a backlog of unconfirmed trades that threatened to undermine the market.

After the collapse of Bear Stearns Cos. in March the Fed intensified its demands, engineering a list of efforts among the 17 largest dealers including creation of a clearinghouse overseen by the Fed that would absorb the failure of a market-maker.