No, not Client 9 - we’re talking Sheriff of Wall Street here.
Governor David Paterson, who succeeded Eliot Spitzer in March, has decided to regulate a portion of the “market for short selling bonds” - by which he means credit default swaps.
Mr Paterson and Eric Dinallo, New York State’s insurance overlord, have effectively reclassified certain of these swaps as insurance, and therefore subject to state regulation.
But here’s where the statement gets confusing. On the one hand, Messrs Paterson and Dinallo say they want to “limit harm to markets from damaging speculation”. But, as the fourth paragraph of the statement makes clear, this oversight will not apply to “naked” CDS.
“Naked CDS” describes a trade in which the buyer of protection does not actually own the underlying bond referenced the by credit default swap contract. Such a trade is essentially speculative, rather than an “insurance contract” taken out to protect against the risk of default by the bond issuer, or even a pure play negative basis trade.
In that sense, it can be seen as similar to a naked short sale - with significant caveats, like the possibility that the trade is part of a more complicated hedging position.
But since Paterson and Dinallo can’t actually regulate naked CDS, the anti-evil-short-selling-bastards posturing of the release doesn’t make any sense. Indeed, these two would-be sheriffs are actually going after the sell-side.
Under the Paterson plan, the New York State Insurance Department would require anyone selling CDS to “non-naked” buyers to prove that they can actually meet their obligations. Which means? Simply that if this rule had been implemented five years ago, the MBIAs, Ambacs and AIGs of the world would have had to set aside $x amount of capital every time they sold CDS - and they wouldn’t have been in a situation of potentially being unable to meet claims.
[UPDATE: MBIA’s communications honcho Kevin Brown strongly disagrees with this assertion. He makes a fair point - that MBIA and its rivals did have to set aside capital in the first instance, but as the relative fates of the bond insurers makes clear, those reserves were generally inadequate. The wording of the above has been amended.].
And as of January 1, “non-naked CDS” (clothed?) can “only be issued by entities licensed to conduct insurance business”.
Which, if true, doesn’t seem to make much sense. If a clothed CDS is one which references an asset you own, why would an insurer be selling CDS on it anyway? And, from another point of view, this would seriously limit the number of possible counterparties to a trade. Does that mean investment banks can’t sell such CDS, for instance? Hopelessly unclear, and hopefully, due to be revised.
Still, the new rules would “strictly limit” financial guarantee insurers from guaranteeing CDOs. Per the statement:
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.
No kidding, and what should be especially galling for the regulators is like the likes of AIG circumvented rules forbidding them from playing with fire derivatives by setting up special purpose vehicles to sell CDS contracts. Look how well that turned out.
The bond insurers haven’t fared much better - the major players, including MBIA and Ambac, collectively wrote CDS contracts on more than $100bn of subprime-backed CDOs, and are now dealing with the consequences.
Paterson and Dinallo would also “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 - which is a big step forward.
The reforms will also require written risk control and underwriting policies, higher capital and reserves at financial guarantee insurers and expanded reporting.
So despite the ridiculous posturing, the Paterson plan isn’t actually a bad place from which to start. If only they’d written it better - and left out that bit calling on the federal government “to regulate the rest of the swap market”.
UPDATE: As JCK rightly points out, this should be familiar territory for NY’s various regulators.
