State will begin regulating part of credit default swap market, says Paterson

Governor David Paterson announced Monday that New York state will begin regulating part of the credit default swap market beginning in January.

Credit default swaps, similar to the stock market's short-selling technique, profits from falling values of bonds. The credit default swap market is worth about $62 trillion; Gov. Paterson also said Monday he wanted the federal government to help regulate the massive market.

For its part, the New York Insurance Department issued new guidelines Monday that, for the first time, establish that some credit swaps are insurance and therefore subject to state regulation.

"I urge the federal government to follow New York's lead once again by regulating the rest of the credit default swap market, which will have a positive impact on our collective efforts to get the national economy back on track," said Gov. Paterson in a written statement.

Added Eric Dinallo, New York State Insurance Department Superintendent, "This is primarily a credit crisis, not an equity crisis, and that is where the focus should be now. What New York State is doing fits our role as insurance regulators," he said in a statement. "We are providing a way for those with an insurable interest to protect themselves and we are going to ensure that whoever sells them that protection is solvent -- in other words, can actually pay the claims."

"There is currently no such protection for policyholders," Dinallo said. "However, we are not regulating naked credit default swaps."

"Naked swaps" are swaps bought by speculators -- purchasers who do not own the underlying bond. Speculation in a company's bonds can under some circumstances hurt that company's ability to borrow.

Credit default swaps played a major role in the financial problems at AIG, Bear Stearns and the bond insurance companies, said Paterson.

"Earlier this year, New York was the first state in the nation to mandate certain regulatory control of the subprime lending market, and today's action is just the next step," said Paterson.

Under the new standards, the new practices are as follows:

1. Strictly limit financial guarantee insurers from guaranteeing collateralized debt obligations or "CDOs"-securities based on the payments from many mortgages. These CDOs, often based on subprime mortgages, have caused substantial financial difficulties for many commercial and investment banks. Credit default swaps on CDOs are the source of a large part of AIG's financial troubles.

2. Institute a number of measures to limit risks for financial guarantee insurers. For example, the rules better define concentration risk, which is the risk from insuring too many bonds from a single source. The new rules include originators and servicers of debt as sources to consider.

3. Require written risk control and underwriting policies.

4. Increase the minimum amount of capital and reserves a financial guarantee insurer must maintain.

5. Expand reporting requirements.