New York Governor David Paterson said yesterday that the state will begin regulating part of the $62 trillion credit default swap (CDS) market next year because a lack of regulation in that area of finance has contributed to the current credit crisis. This step may accelerate oversight of an industry blamed for helping to almost bring down the US financial system over the last year.
The governor said that the state would 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. Consequently, the New York Insurance Department issued guidelines on Monday that establish some types of credit default swaps as insurance, subjecting them to state regulation.
CDS are a type of derivative contract that pay out in the event of default. These types of derivatives have grown very quickly in the past 10 years because they allow market participants to hedge against the risk of holding debt, while also letting traders speculate more easily on the fortunes of companies.
While the market has ballooned, it remains lightly regulated. That's sparked concern that problems in the market could exacerbate stresses in the broader economy and other financial markets.
Paterson's office said the goal of regulating the swaps is not to stop sensible economic transactions, but to ensure that sellers have sufficient capital and risk management policies in place to protect the buyers, who are in effect policyholders.
Under Paterson's plan, the New York State Insurance Department would require entities selling CDS to bondholders to show they can actually pay the claims if there is a default. Under the new guidelines, which will become effective in January, such contracts could ''only be issued by entities licensed to conduct insurance business,'' according to the statement yesterday.
American International Group (AIG) was a big seller of protection in the CDS market. The giant insurer wrote CDS-based contracts that guaranteed mortgage-related securities known as collateralized debt obligations.
When the housing market began to slump last year, AIG suffered big write-downs on the exposures, eventually pushing the company into the arms of the government in an $85 billion bailout.
"At AIG, for example, insurance companies regulated by the state are required to hold substantial reserves and as a result those companies are solvent and able to pay claims," Paterson said in a statement. "However, a major part of AIG's problems were created when credit default swaps were issued by a non-insurance unit that did not hold sufficient reserves."
The phenomenon may not be restricted to New York alone with Paterson lobbying for national acceptance of the plan. ''The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing,'' he said, ''I urge the federal government to follow New York's lead once again by regulating the rest of the credit- default swap market.''
The traders in these instruments, were predictably, not happy. New York regulators threaten ``to disrupt global derivatives markets'' through this action, said Robert Pickel, CEO 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.