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CDS as Insurance

By Anonymous

New York Governor David Paterson's announcement that the state of New York will begin regulating certain credit default swaps (CDS) as insurance sent shockwaves through the CDS market. Insurers are closely regulated at the state level?they must be licensed to write insurance policies, adhere to strict minimum capital requirements, etc. Subjecting CDSs to state insurance regulation could potentially cripple swap dealers, as they would have to raise significant capital, and quickly, to satisfy the minimum capital requirements. Treating CDSs as insurance would also decrease the liquidity of the CDS market at a time when liquidity is very hard to come by.

Gov. Paterson's announcement might have been a surprise to traders, but it wasn't a surprise to structured finance lawyers. Back in the late '90s and early 2000s, there was a heated debate about whether the law should treat CDSs as insurance. Since most CDS transactions were executed in New York (at that time, at least), the financial industry focused its efforts on that state. Under New York law, an "insurance contract" is defined as follows:

"Insurance contract" means any agreement or other transaction whereby one party, the "insurer", is obligated to confer benefit of pecuniary value upon another party, the "insured" or "beneficiary", dependent upon the happening of a fortuitous event in which the insured or beneficiary has, or is expected to have at the time of such happening, a material interest which will be adversely affected by the happening of such event.

Does a CDS fit within New York's definition of an "insurance contract"? Many lawyers, including yours truly, spent a good deal of time arguing over that very question. In 2004, the New York legislature appeared to end the debate, ruling that CDSs would not be regulated as insurance. But the way the state exempted CDSs from regulation as insurance left many finance lawyers uneasy. The state amended the insurance code to define "credit default swap" as:

[A]n agreement referencing the credit derivative definitions published from time to time by the International Swap and Derivatives Association, Inc. or otherwise acceptable to the superintendent, pursuant to which a party agrees to compensate another party in the event of a payment default by, insolvency of, or other adverse credit event in respect of, an issuer of a specified security or other obligation; provided that such agreement does not constitute an insurance contract and the making of such credit default swap does not constitute the doing of an insurance business.

This is the legal equivalent of a wink-and-a-nod. The definition never explicitly states that a CDS isn't an insurance contract, it just indicates that a CDS is not the same as an insurance contract. This was less than bullet-proof, and suggested that the state wanted to retain the option to change its mind on the proper classification of CDSs in the future. The head of my department at the time was particularly unhappy with this solution, and he, along with a bunch of other lawyers, wanted to push for further clarification (if I remember correctly, through an AG opinion). But because the uber-paranoid ISDA was unwilling to relinquish any control over the development of CDSs?especially to a state government?no further clarification was obtained.

(For the record, I don't think New York state will actually make good on its threat to regulate certain CDSs as insurance. The state says it will start regulating the CDSs on January 1st, but Gov. Paterson and Eric Dinallo, the Insurance Commissioner, have both pushed for the federal government to step in and regulate the CDS market before then. It's also clear that a central clearinghouse will be up and running before the end of the year, which would presumably eliminate the need to bring CDSs under the umbrella of NY insurance regulations. My sense is that Gov. Paterson just wants to win political points by appearing tough on the villain-du-jour, credit default swaps, without actually having to follow through on his tough talk. It's a savvy political move, if somewhat reckless financially. We'll see if I'm right on January 1st, I guess.)

Full post as published by Economics of Contempt on October 25, 2008 (boomark / email).