New York Trying To Regulate CDS Written With Underlying Bond

Although it seems minor, this is actually major news. Bloomberg is reporting that the State of New York is attempting to require CDS contracts to be treated as insurance if the CDS buyer owns the underlying bond as well.

The state will treat contracts in which the buyer also owns the underlying security as insurance, Paterson said today in a news release. All such contracts would have to be purchased from regulated bond insurance companies, said David Neustadt, a spokesman for New York State Insurance Superintendent Eric Dinallo. Contracts in which investors buy protection against a default but don't own the actual security won't be treated as insurance, according to the release.

I'm not sure which insurers would be willing to write the CDS-type insurance. Forays into CDS writing by the monoline bond insurers ended up in a huge disaster. American giant AIG also blew up due to its CDS contracts. Admittedly, all these blow-ups are with mortgage CDS-type insurance, so other areas (interest rate, currency, corporate bonds, etc) may be ok. Right now we have non-insurance companies like Primus Guaranty (PRS)--incorporated in Bahamas--who write CDS, as well as hedge funds.

I think this attempt is going to be difficult to pull off. Insurance companies are heavily regulated and have strict requirements to hold sufficient capital, and this means it would take some time to get everyone set up. Capital seems to be scarce and the last thing anyone wants to fund right now is some insurance company writing CDS-type insurance.

All this may just be an attempt to stunt the growth in CDS. I don't work in the industry or anything, but my impression is that people are writing CDS as if it was going out of fashion, with little sense of the big picture. My guess is that if there are some "unexpected" events, a big chunk of the CDS writers are going to be bankrupt and won't pay up. This already happened in the mortgage bond area, as the following UBS case from last year shows:

In one notorious case, a small hedge fund agreed to insure UBS AG, the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million.

The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee -- and capitalized it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44 percent.

But in the summer of 2007, as home owners began to default, things got ugly. UBS demanded the hedge fund put up additional collateral. The fund balked. UBS sued.

Perhaps this is just an attempt to separate the CDS buyers who are buying it with the naive hope that the hedge fund or whoever that is on the other side will pay up if the bond defaults; from those that are simply using it to speculate or hedge various actions.