Default swaps are insurance policies insists Dinallo

US credit derivatives dealers are facing a clampdown by New York’s insurance regulator following the near-collapse of AIG and monolines. From 2009 onwards, any firm based in New York State exposed to credit risk that wants to buy credit default swap protection will need to go to a regulated insurance entity, according to proposals announced by the state’s department of insurance.

With his state accounting for 28% of the US bond insurance market, and the home to the majority of US derivatives dealers, New York’s superintendent of insurance, Eric Dinallo, has been at the centre of efforts to rescue troubled monolines via commutation of their CDS contracts. But it was the near collapse of $1 trillion giant AIG in the wake of CDS collateral calls on Tuesday, September 16, that ‘crystallised’ Dinallo’s decision to clamp down on the credit derivatives industry.

The monolines experienced problems after offering protection on structured credit products such as collateralised debt obligations (CDOs) and asset-backed securities (ABS) created by investment banks. After losing their triple-A credit rating, there were fears that some monolines could be tripped into insolvency by the nature of their structured credit obligations, which were based on mark-to-market derivatives valuations.

AIG, although best known as an insurance group, used its unregulated financial products business to build up an under-capitalised $441 billion notional position in super senior credit default swaps linked to CDOs. “Approximately $307 billion…was written to facilitate regulatory capital relief for financial institutions primarily in Europe”, AIG stated in a regulatory filing.

By August, after two quarters of heavy losses, AIG was warning that it faced up to $18 billion of immediate collateral calls and early termination payments in the event of a downgrade of its credit rating. By early September, AIG’s lenders and counterparties began pulling liquidity lines on the firm.

Dinallo claims credit for helping to facilitate new players such as Warren Buffett’s Berkshire Hathaway to take the place of troubled monolines and continue writing bond insurance for municipal borrowers. And in his capacity as administrator for insurer bankruptcy – or ‘rehabilitation’ under New York law, Dinallo has important powers to delay payment to creditors. This encouraged the creditors of two monolines – SCA and FGIC – to agree deals that write off structured credit exposure.

But AIG’s problems were of a different scale. Late on Friday, September 12, Dinallo received a phone call from AIG’s lawyers asking for permission to withdraw capital from its insurance subsidiaries to pay cash calls. Over the course of a weekend spent in AIG’s offices, Dinallo put together a deal between New York and the Pennsylvania insurance regulator to allow $20 billion of surplus capital to be withdrawn. But in the end the facility was not needed because the US Federal Reserve agreed to provide a loan of $85 billion in return for a 79.9% equity investment in AIG.

Dinallo concedes that the use of credit default swap contracts (CDS) by US insurers and their affiliates was a dangerous development that his department was complacent about. And he says that New York law already defines CDS contracts as insurance policies, so long as the protection buyer has existing credit exposure and has incurred a loss. However, he says that the law was never enforced out of deference to the derivatives industry.

“We could have had these written straight up as insurance policies by the monolines, but Wall Street wanted it done by CDS. In an attempt to work with the companies and Wall Street, CDSs of this type seemed to be the appropriate vehicle. We didn’t see a reason not to because we never foresaw the possibility of rehabilitation on this scale.”

Normal bond insurance policies are only payable if the underlying issuer defaults, which remains the case even if the insurer goes into rehabilitation. However, CDS contracts can require immediate settlement at their mark-to-market value if the writer of protection defaults. This would have potentially left municipal and project finance bond insurance policyholders with nothing – prompting Dinallo to threaten to use the rehabilitation process to stop payment.

“This is why we have our issues with credit default swaps. The monolines wrote them with a lot of bells and whistles – default, acceleration, collateralisation etc. That makes it very tricky – if the monoline is deemed to be insolvent or restructured, I get a pay out right now. To all of a sudden have people with priority and acceleration is not how you deal with a distressed book.”

Although he insists that the giant’s insurance subsidiaries were never at risk, the problems at AIG led Dinallo to broaden his reforms to cover all sellers of credit default protection in New York. Only protection sellers who can prove that their counterparties have no exposure to the underlying reference credit will be exempt from the rules.

However, the Securities & Exchange Commission (SEC) has separately requested supervisory powers over credit derivatives from the US Congress. Dinallo suggests that like New York, the SEC may in fact already have such legal powers. A spat with the International Swaps & Derivatives Association (ISDA), whose standardised contracts currently govern the CDS market, seems inevitable. According to Dinallo, “We could work with them to come up with a holistic solution.”

New York’s deputy superintendent of insurance, Michael Moriarty, told Life & Pensions magazine how the proposed new rules will prevent credit derivatives abuses. “Contracts will not have these accelerations or termination events, but will provide credit protection. In the event that an issuer defaults, a financial guarantor will step into the shoes of the issuer. It will be selling credit protection, but it will not be selling the mark-to-market protection.

There won’t be an outright prohibition on asset-backed securities because securitisation is essentially a good diversification tool on a systemic basis. We’re not saying that all securitisation is bad, but I don’t think you’re going to be seeing much hyper securitisation any more. If the financial guarantors wrap these products, the products will not be subordinated; there will be high collateral behind them.”

“As regulators we need to better assess how these companies measure the risk and how they manage it, specifically the models that these financial guarantors are using to calculate their risk. It’s something that we did not dive into deeply in the past. These companies will also be disclosing much more granular information on the securities that they insure, on the types of securities and on their diversification.”

Some observers say that rating agencies – which lavished triple-A ratings on monolines and subprime CDOs alike – should share some of the blame too. But Dinallo reserves most criticism for the investment banks. “Remember – before we criticise the rating agencies, although there are embedded conflicts that they have to deal with and those have been published recently, the truth is that the most sophisticated minds on Wall Street still blew it too.”

Insisting that his expanded regulatory scope “isn’t a land grab”, Dinallo suggests that derivatives dealers planning to continue selling CDS out of New York should set up a monoline subsidiary. The alternative may be to trade CDS out of London, where the UK Financial Services Authority says that the contracts are ‘adequately’ covered by the EU Market Abuse Directive.

Nicholas Dunbar

A full interview with Eric Dinallo will be published in the November 2008 issue of Life & Pensions magazine.