Client Alert

Credit Default Swaps Under Siege

October 10, 2008

The multi-trillion dollar market for credit default swaps ("CDS") has come under regulatory scrutiny for the first time on several levels.

Most recently, New York Attorney General Andrew Cuomo has announced¹ that he is investigating whether short sellers abused the CDS market through rumor-mongering designed to produce profits following negative publicity concerning Lehman Brothers, Washington Mutual and other troubled financial institutions. Cuomo has subpoenaed a number of hedge funds, as well as providers of information on market trades and pricing, regarding trades occurring subsequent to July 1, 2008 with particular focus on CDS transactions consummated in September.

Unlike some investigations by state attorneys general that courts have found to be preempted under federal law – – including an aborted attempt² by the New York AG to investigate sub-prime lending by national banks – – Cuomo's investigation will not face opposition from the Securities and Exchange Commission, at least until such time that Congress may enact enabling legislation allowing the SEC to deem CDS to constitute securities and to regulate them accordingly. In recent Congressional testimony³, SEC Chairman Christopher Cox specifically advocated rendering CDS trades subject to SEC regulation. Whichever candidate for President is elected, greater SEC oversight of CDS is virtually certain.

Federal regulation of CDS transactions would complicate, if not supersede, the recently announced plans of the New York State Insurance Department (the "Department") to regulate certain CDS as insurance products. In a marked change from its previous position, the Department issued Circular Letter No. 19 (2008) (”Circular 19”), the most significant aspect of which is the Department’s apparent change of position with respect to the circumstances under which a CDS may constitute an “insurance contract” and whether a protection seller’s issuance of a CDS constitutes the “doing of an insurance business.”

Since June 2000, CDS issuers and buyers have taken comfort from an opinion of the Department’s Office of General Counsel (“OGC”) that a CDS is not an insurance contract if, among other factors, any future payment thereunder to the protection buyer “is not conditioned upon an actual pecuniary loss.” However, Circular 19 indicates that, prospectively, the Department will deem the issuance of a CDS to constitute the transaction of insurance within the meaning of New York Insurance Law § 1101 in instances in which the protection buyer, at the time at which the CDS is entered into, “holds, or reasonably expects to hold, a ‘material interest’ in the referenced [i.e., underlying financial] obligation.” Although Circular 19 states that greater clarification on this point will be provided in a forthcoming Department OGC opinion, prospective counterparties should expect that the Department will consider a CDS to be an insurance contract in every case in which the protection buyer owns or has an insurable interest in the underlying financial instrument that is the subject of the CDS.

Circular 19 does not address the situation in which a CDS does not reference a specific underlying obligation (i.e., a “naked swap”), which the press release accompanying Circular 19 stated was not considered by the Department to constitute "insurance." Presumably, because in such a case the protection buyer in the CDS transaction would not have an insurable interest in an underlying obligation, under Circular 19’s formulation the “naked swap" could not constitute “insurance” subject to the Department’s regulation.

In 2004, the New York Legislature amended Article 69 of the Insurance Law to define the term "credit default swap" and to allow financial guaranty insurers to insure CDS that referenced a pool of obligations or pools of other CDS. Section 6901 was modified to include a definition of the term "credit default swap" as "an agreement referencing the credit derivative definitions published . . . by the International Swap and Derivatives Association, Inc. . . . 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." Contrary to longstanding market practice, the Department now interprets this provision to mean that certain CDS may constitute insurance contracts and therefore may not be issued by financial institutions that are not appropriately licensed insurers. The Department's newly adopted view raises interesting issues of statutory interpretation that we will explore in a forthcoming article in Chadbourne's Insurance/Reinsurance Newswire.

<sup>1. The New York Times, September 26, 2008.
2. See Clearing House Assoc. v. Cuomo, 510 F3d. 105.
3. USA Today, September 23, 2008.
*Clients who regularly deal with financial guaranty insurers licensed in New York should note that the Circular Letter also sets forth a series of “best practices” for such insurers that provide insurance or “wraps” for municipal bonds or asset-backed securities (ABS) through either CDS or financial guaranty policies. The Department intends to seek legislation or issue regulations imposing increased capital and surplus requirements, additional reporting obligations and stricter risk management standards as of January 1, 2009. The Circular Letter also sets forth the Department's more stringent view regarding a financial guaranty insurer's ability to insure collateralized debt obligations ("CDOs") supported by asset backed securities. In particular, financial guaranty insurers will be required to measure their exposure to various types of mortgage collateral according to the identity of the original lender and the loan servicer and the year of each ABS’s origination. The insurer will no longer be permitted to insure interests in CDOs backed by other CDOs unless: (i) the insured interest is unsubordinated and has an investment rating of “single-A” or higher; (ii) the underlying collateral consists solely of government agency issued or guaranteed debt; (iii) the collateral pool consists entirely of ABS already insured by the insurer; or (iv) the Superintendent of the Department determines that the insurance is without undue risk to the insurer and its policyholders. Also, the Department expects insurers to discontinue the issuance of policies related to CDS other than transactions with respect to which: (i) the CDS only covers failures to pay by the issuer when the failure is the result of a financial default or insolvency; (ii) neither the CDS nor the related policy 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 issuing the policy; and (iii) neither the CDS nor the related policy requires the insurer to post collateral.</sup>