United States: New York To Start Regulating Certain Types Of Credit Default Swaps As Insurance

Article by Lawrence R. Hamilton , Joel S. Telpner , Charles M. Horn and J. Paul Forrester

Originally published September 24, 2008

Keywords: New York State Insurance Department, credit default swaps, CDS, derivatives, ISDA, credit event, monoline

In a major departure from prior precedent, New York Governor David A. Paterson announced on September 22, 2008, that the New York State Insurance Department (the "Department") would start regulating certain types of credit default swaps (CDSs) as insurance.¹ Beginning on January 1, 2009, if the protection buyer under a CDS owns the underlying security on which it is buying protection, then the CDS will be treated as an insurance contract. Among other things, this means that only licensed financial guaranty insurance companies will be authorized to issue that type of CDS. This decision represents a dramatic change from the positions previously taken by the Department with respect to CDS transactions. Governor Paterson's news release states that to avoid market disruptions, the Department's new interpretation of the New York Insurance Law with regard to CDSs will not take effect until January 1, 2009, and will not affect any existing CDSs, but only new CDS transactions entered into on or after January 1, 2009. Concurrently with the Governor's announcement, the Department issued Circular Letter No. 19 (2008), announcing new "best practices" for financial guaranty insurers and explaining the rationale for the Department's new direction regarding the regulation of certain types of CDSs.²

Background

A CDS is a type of derivative contract that is typically documented under documentation developed by the International Swaps and Derivatives Association (ISDA), including confirmations referencing the 2003 Credit Derivatives Definitions as published by ISDA. Under a CDS, the protection buyer makes periodic payments to the protection seller in exchange for a right to receive payment from the protection seller if there is a "credit event" with respect to one or more categories of obligations issued by a specified "reference entity." Credit events typically include a default by the reference entity in paying amounts when due under the identified obligations, but they can also include events such as the bankruptcy or restructuring of the reference entity. While the terms of many CDS may be standardized, CDS transactions can also be highly tailored and the documentation heavily negotiated.

A CDS contract is often used as an alternative to a financial guaranty insurance policy to protect the holder of a debt instrument against payment and other defaults under the debt instrument. However, the terms of a CDS typically do not require the protection buyer to actually hold the covered obligations, or to suffer an actual loss, in order to be entitled to payment from the protection seller.³ For this reason, the Department had — until September 22, 2008 — taken the position that a CDS was not an insurance contract and was not subject to insurance regulation.

The Department's reasoning (prior to September 22, 2008) was based on Section 1101(a)(1) of the New York Insurance Law, which sets out the following definition of an "insurance contract":

In a CDS transaction, the protection seller is obligated to confer a benefit of pecuniary value on the protection buyer dependent on the happening of a credit event. In addition, a credit event seems to qualify as a "fortuitous event" (defined in Section 1101(a)(2) of the New York Insurance law as "any occurrence or failure to occur which is, or is assumed by the parties to be a substantial extent beyond the control of either party"). The only remaining question is whether the protection buyer "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." In a June 16, 2000, opinion issued by the Department's Office of General Counsel (the "2000 OGC Opinion"), the Department answered "No" to that question — focusing on the fact that the terms of a CDS do not require the protection buyer to actually hold the reference obligation, or to suffer an actual loss, in order to be entitled to payment from the protection seller. Consequently, the 2000 OGC Opinion concluded that a CDS in which the protection seller is obligated to make payment to the protection buyer upon the happening of a credit event, where such payment is not dependent upon the protection buyer having suffered a loss, does not constitute a contract of insurance.

To be clear, the 2000 OGC Opinion did not say that a CDS could never be an insurance contract. It only said that a CDS was not an insurance contract so long as payment to the protection buyer was not dependent upon the protection buyer having suffered a loss. But because this was a characteristic feature of the standard ISDA terms for CDS transactions, and because the designers of bespoke CDS transactions were generally careful to include in their structures a similar "disconnect" between payment to the protection buyer and the protection buyer's actual loss, the effect of the position articulated in the 2000 OGC Opinion was to place CDS transactions outside the scope of New York insurance regulation.⁴

There has long been speculation about the extent to which the Department's reasoning in the 2000 OGC Opinion was "outcome driven," i.e., based on a reluctance by insurance regulators to become involved in regulating a portion of the derivatives market, as well as a recognition (since insurance in the United States is regulated almost entirely at the state level) that subjecting derivatives transactions to 50 different state insurance regulatory regimes would be impractical. Without taking a position on the question of state versus federal regulation of insurance, we cannot help but wonder whether — if insurance had been regulated at the federal level — a federal regulator's decision on whether or not to treat CDS as insurance might have gone the other way.

Development Of The CDS Market

The CDS market has grown to gigantic proportions. According to ISDA, the aggregate notional exposure of the overall CDS market grew from US$919 billion at the end of 2001 to more than US$62 trillion at the end of 2007.⁵ Moreover, doubts about the ability of counterparties to meet their CDS obligations have been a major factor in exacerbating the recent financial crisis. Additionally, because CDSs have not been treated as insurance contracts, protection sellers have not been required to maintain the types of reserves against their obligations that insurance companies are required to maintain.

Meanwhile, the insurance companies that are specifically authorized in New York to issue financial guaranty insurance policies (often referred to as "monoline" insurers) have also become significant participants in the CDS market. These monoline insurers were already authorized to issue financial guarantees under Article 69 of the New York Insurance Law ("Article 69"), but by participating in the CDS market the monoline insurers were able to expand the effective scope of their guarantees beyond what would otherwise have been permitted under Article 69.

Rather than issuing CDS contracts directly, monoline insurers generally established affiliated special purpose vehicles (often referred to as "transformers") to issue CDS contracts on structured finance obligations; the CDS contracts were then backed by financial guaranty insurance policies issued by the monolines. The transformers, as CDS protection sellers, were able to offer certain contract terms that could not be legally included in policies that the financial guaranty insurer issued directly. If a credit event occurred, the transformer would be obligated to pay the protection buyer. Then, if the transformer failed to pay, the financial guaranty insurer would be required to pay under its guarantee of the transformer's obligations, even though the credit event triggering those obligations might have been beyond the scope of risks that could be covered by a financial guaranty insurance policy.

For example, Article 69 limits the triggering event for payment under a financial guaranty insurance policy to a failure by the underlying obligor to pay an obligation when due. Article 69 also prohibits acceleration of the payments required to be made under a financial guaranty insurance policy unless such acceleration is at the sole option of the insurer. By contrast, a CDS may specify "credit events" or "termination events," such as an insolvency or credit downgrade of the reference entity, that do not necessarily involve a failure to pay an obligation when due, and the termination payment required under a CDS may be economically equivalent to an acceleration of future payment obligations. Nevertheless, the Department's Property Bureau expressly permitted monolines to issue these types of financial guarantees of CDS, subject to certain conditions, and this permission was incorporated in Article 69 of the New York Insurance Law in 2004.

The Department's New Regulatory Approach

Against the backdrop of several months of ratings downgrades of most of the monoline insurers, followed by the near bankruptcy of AIG, the Department announced a new regulatory approach on September 22, 2008. The new approach, described in detail in Circular Letter No. 19 (2008), has two major components. The first component is the formulation of "best practices" that monolines licensed in New York will be expected to follow, beginning on January 1, 2009.⁶ The Department has stated that it intends to promulgate regulations or seek legislation, as necessary, to formalize these guidelines. The implementation of these best practices will make the regulation of monoline insurers in New York more stringent. With regard to the CDS market, they will require monoline insurers to limit their issuance of policies on CDS to transactions where:

• The monoline guarantees only those types of risks specified in Section 6901(a)(1)(A) of Article 69, namely, only a failure by the underlying obligor to pay an obligation when due;
• Neither the CDS under which the transformer sells protection to the protection buyer, nor the insurance policy under which the insurer guarantees payment by the transformer, defines a credit event, termination event, or event of default to include a change in the credit quality, rehabilitation, liquidation or insolvency of the insurer; and
• Neither the terms of the CDS nor the financial guaranty insurance policy requires the insurer to post collateral.

In making these changes, the Department's goal (as stated in Circular Letter No. 19) is to confine participation by financial guaranty insurers in the CDS market "to those transactions in which the insurers' risk is roughly comparable to the amount and timing of risks assumed when directly insuring bonds." The Department explains that it is seeking these restrictions in order to preclude the possibility that CDS counterparties will present claims ahead of other insured parties or otherwise gain a preferred position if the monoline becomes subject to an insolvency proceeding.

The second major component of the Department's new regulatory approach will have an impact extending far beyond the realm of monoline insurers. Presumably in response to the meltdown of AIG, the Department has decided that beginning on January 1, 2009, if the protection buyer under a CDS owns the underlying security on which it is buying protection, then the CDS will be treated as an insurance contract.⁷ In other words, the 2000 OGC Opinion no longer represents the position of the Department with respect to those types of CDS transactions.

Under the 2000 OGC Opinion, a CDS was not an insurance contract if the payment by the protection buyer was not conditioned upon an actual pecuniary loss. However, in the words of the Department's newly issued Circular Letter No. 19, "that opinion did not grapple with whether, under Insurance Law § 1101, a CDS is an insurance contract when it is purchased by a party who, at the time at which the agreement is entered into, holds, or reasonably expects to hold, a 'material interest' in the referenced obligation." In other words, the 2000 OGC Opinion focused on the fact that the protection buyer was not required to own the reference obligations, and whether or not it did own the reference obligations was not deemed relevant. That has now changed. Rather than focusing on whether the protection buyer is required to own the reference obligations, the Department is now focusing on whether the protection buyer does in fact own the reference obligations, and perhaps even — based on the language in the statute — whether the protection buyer is expected to own the reference obligations.

The decision to regulate a CDS as an insurance contract where the protection buyer owns the reference obligation has a number of further implications:

• The protection seller under a CDS that is treated as an insurance contract will need to be a licensed financial guaranty insurance company and will need to comply with Article 69's requirements regarding such matters as maintenance of reserves against risk exposures, limitations on single and aggregate risk exposures, limitations on concentrations of risk and limitations on exposure to non-investment grade securities.
• The terms of a CDS that is treated as an insurance contract will need to conform to the restrictions applicable to financial guaranty insurance policies under Article 69. As noted above, Section 6901(a)(1)(A) of Article 69 limits the triggering event for payment under a financial guaranty insurance policy to the underlying obligor's failure to pay obligations when due. This suggests that other types of CDS triggers, such as an insolvency or a credit downgrade of the reference entity, may no longer be permitted.
• Section 6905(a) of Article 69 requires financial guaranty insurance policies to provide that in the event of a payment default by or insolvency of the obligor, there shall be no acceleration of the payment required to be made under such policy unless such acceleration is at the sole option of the insurer. Currently, Section 6905(a) exempts policies that guarantee CDS contracts from this restriction, so long as the acceleration payment is within the insurance company's single risk limits. However, this exemption would not seem to be available if the CDS itself is treated as the insurance policy. In addition, the Department is likely to pursue legislative changes or adopt regulations to eliminate this exemption.
• As discussed above, the Department is asking financial guaranty insurers to abide by certain new best practices when they issue policies that guarantee CDS contracts. It is likely that these same limitations will be applied to any CDS contracts that are treated as insurance contracts after January 1, 2009.
• It is not clear whether the Department intends to apply its new regulatory approach to banks that provide CDS protection. A number of leading US commercial banks, as well as the New York branches and agencies of foreign banking organizations, are subject to comprehensive supervision and regulation by federal and/or state banking authorities, and the Department's Circular Letter No. 19 does not indicate whether the Department intends to apply its new policy to these regulated banks or banking offices. Moreover, under current standards of federal preemption of state regulation, national banks that are subject to regulation and supervision by the Office of the Comptroller of the Currency generally are not subject to state regulation that substantially restricts or interferes with their exercise of federally-authorized banking powers. Although the Financial Modernization Act of 1999 (also known as the Gramm-Leach-Bliley Act) conditionally preserves certain rights of states to regulate the business of insurance that is conducted by banking organizations, national banks' CDS activities have been treated for regulatory purposes aspermissible financial intermediation services and not the business of insurance, and it is questionable whether the Department unilaterally can redefine and regulate national banks' CDS activities as "insurance" for purposes of federal law.
• Also unclear is the extent to which the line of reasoning that led the Department to conclude that a CDS is an insurance contract could also encompass other categories of credit derivatives, such as total return swaps.

What Does The Future Hold?

As Governor Paterson's September 22, 2008 news release makes clear, the Department's regulatory initiatives will have no effect on CDS transactions where the protection buyer does not own the reference obligation. In the case of such "naked" swaps, the logic of the 2000 OGC Opinion still holds true: because the payment to the protection buyer is not dependent on the protection buyer having suffered an actual loss, the CDS is not an insurance contract.⁸ The Department simply has no authority under current law to regulate such CDS transactions. Ironically, the type of CDS that is most prone to speculative use is the type that will be left untouched by New York's new regulatory regime.

This gap in regulatory oversight has not gone unnoticed. In his September 23, 2008, testimony before the Senate Committee on Banking, Housing, and Urban Affairs, SEC Chairman Christopher Cox described on the ability of CDS buyers to "naked short" the debt of companies without any regulatory restriction as a "regulatory hole that must be immediately addressed." He urged Congress to enact legislation providing for the regulation of CDS products "to enhance investor protection and ensure the operation of fair and orderly markets."⁹ In a September 23, 2008, news release, Governor Paterson added his voice to the call for federal regulation of the CDS market, recognizing that the Department's regulatory initiative could only reach a subset of the CDS market.¹⁰ On the other hand, Robert Pickel, the Executive Director of ISDA, responded critically to SEC Chairman Cox's proposal. He said: "Credit derivatives market participants are the first to encourage the SEC to use its authority to ensure attempted manipulation of these markets is punished. However proposals which would seek to treat privately negotiated contracts as securities, or otherwise apply ill-fitting regulatory regimes to these agreements, are likely to deter healthy economic activity and push derivatives into markets where the SEC has no jurisdiction."¹¹

The jurisdictional question is relevant to the scope of the Department's authority as well as the SEC's authority. Assuming the Department's regulation of CDSs in which the protection buyer owns the reference obligation becomes effective on January 1, 2009, as announced, there have been suggestions that the CDS market could avoid such regulation by simply moving to another location, such as London. However, such measures would be effective to avoid New York jurisdiction only if the CDS transactions were effectuated without any contact with parties in New York. Section 1101(b) of the New York Insurance Law provides that doing an insurance business in New York includes such acts as "making, or proposing to make, as insurer, any insurance contract, including either issuance or delivery of a policy or contract of insurance to a resident of this state or to any firm, association, or corporation authorized to do business herein, or solicitation of applications for any such policies or contracts" and "collecting any premium, membership fee, assessment or other consideration for any policy or contract of insurance." Thus, if a particular CDS contract were deemed to be a contract of insurance, then negotiating that contract with a counterparty located in New York, delivering that contract to a counterparty located in New York or collecting premiums on that contract from a counterparty located in New York would all constitute doing an insurance business in New York and would subject a protection seller that was not licensed as an insurance company to statutory penalties for doing an unauthorized insurance business.

However, if the federal government decides to enact a regulatory regime for the CDS market, it is likely that the partial regulatory regime announced by the Department on September 22, 2008, would be withdrawn (or even pre-empted by the federal legislation). So, depending on federal regulatory developments, it may turn out to be the case that the lasting effect of the Department's September 22, 2008, will be limited to an increased stringency in the regulation of monolines.

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Footnotes

1. The Governor's news release is available at http://ins.state.ny.us/press/2008/p0809224.pdf.

2. Available at http://ins.state.ny.us/circltr/2008/cl08_19.htm or http://ins.state.ny.us/circltr/2008/cl08_19.pdf.

3. CDS do not preclude the protection buyer from owning or otherwise having exposure to the covered obligations and in many cases protection buyers do indeed own the covered obligations. However, even in that case, the amount paid to the protection buyer under the CDS following a credit event may not be the same amount as the loss, if any, suffered by the protection buyer in connection with the covered obligations.

4. CDS can be either cash settled or physically settled. In the case of a cash-settled CDS, following a credit event the protection buyer usually receives the difference between the par value of the covered obligation and the post-default market value. In the case of a physically-settled CDS, following a credit event, in exchange for the delivery by the protection buyer of an eligible obligation, the protection seller pays the par amount.

5. See ISDA Market Survey at http://www.isda.org/statistics/pdf/ISDA-Market-Survey-historical-data.pdf.

6. Most, but not all, of the monoline insurers are organized in New York and the Department is therefore their primary regulator. However, even monoline insures that are domiciled in states other than New York will be subject to the New York Insurance Law as interpreted and applied by the Department if they are licensed to do business in New York. Not only does the New York Insurance Law apply to their activities in New York but, in addition, Section 1106 of the New York Insurance Law (the so-called "Appleton Rule") prohibits an insurer organized in a state other than New York from doing any kind of insurance business outside of New York that is not permitted to be done in New York by similar insurers organized in New York without the permission of the Department.

7. Interestingly, the new regulations do not alter the methodology by which the amounts payable by the protection seller are calculated. That is to say, the payment received by the protection seller will not necessarily bear any direct relationship to the amount of actual loss the buyer may have incurred. The possibility of the protection buyer receiving a payment in excess of the amount of its actual loss raises additional concerns. In a property insurance context, an insurance policy would generally be considered void to the extent that it purports to provide coverage in excess of the insured's "insurable interest." If that principle were applied to financial guaranty insurance, a court might refuse to enforce the protection seller's payment obligation to the extent it exceeded the protection buyer's actual loss. This would hardly be effectuating the intent of the parties to the CDS.

8. It is an interesting question whether a CDS that was intended by the protection buyer to be a "naked" swap but turned out not to be such because the trading desk that entered into the CDS was unaware that another trading desk at the same company happened to own the reference obligation (not a far-fetched scenario in a large financial institution) would be treated as a "naked" swap or a contract of insurance under the Department's interpretation.

9. Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions by SEC Chairman Christopher Cox before the Senate Committee on Banking, Housing, and Urban Affairs, September 23, 2008, available at http://www.sec.gov/news/testimony/2008/ts092308cc.htm.

10. Available at http://www.state.ny.us/governor/press/press_0923083.html.

11. Available at http://www.isda.org/press/press092308.html.

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