New York to Regulate Credit-Default Swaps, Governor Paterson Says

On Monday Governor David A. Paterson said that New York would begin regulating credit-default swaps, the arcane financial instruments that were little known outside Wall Street before the credit crisis. 
 
New state regulations will take effect on Jan. 1, but the governor said New York had jurisdiction to regulate only about a fifth of the sprawling market, and he called on the federal government to take steps of its own to oversee credit-default swaps, which have gone unregulated. 
 
Credit-default swaps essentially function like insurance contracts to protect bond buyers from the risk that companies will default, but over the years they have become a favorite tool of speculators who use them to bet that a certain company will fail. 
 
Exposure to the roughly $62 trillion market was one of the main reasons that the American International Group, the insurance giant, required a federal bailout, and contributed to the crises that led to the collapses of Bear Stearns and Lehman Brothers. 
 
The governor’s move reverses previous state policy, which did not consider any credit-default swaps to be insurance products. 
 
“The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing,” the governor said in a statement. “While I applaud the recent federal intervention to stabilize the market — and thus our entire economy — it is important we also take the next step as a nation by regulating areas of the market which have previously lacked appropriate oversight.” 
 
In an interview Monday, Mr. Paterson added that credit-default swaps were “the real problem with A.I.G.” 
 
“When we peeled back the onion, we found out that A.I.G. had so many credit-default swaps that we couldn’t calculate how much money they probably had wasted,” he said. 
 
Last week, Mr. Paterson’s administration allowed A.I.G. to borrow $20 billion from its own subsidiaries to help bolster its capital, not long before the federal government announced an $85 billion bailout. The credit crisis is expected to weigh heavily on New York, which derives a fifth of its tax revenue from Wall Street. 
 
Officials at the Federal Reserve and the Treasury Department had no immediate comment on the governor’s plan, or on his call for federal regulation. Ben S. Bernanke, the Federal Reserve chairman, is scheduled to testify before Congress on Tuesday, and credit-default swaps are likely to be on the agenda. 
 
The governor said the state’s insurance department would begin regulating credit-default swaps as insurance products in cases where the buyer of the swap also owns the underlying bond it is meant to back. 
 
In those cases, only licensed insurers will be able to issue credit-default swaps. New guidelines will also increase minimum capital requirements and the reserves that financial institutions must maintain. 
 
Rules will also be aimed at preventing financial institutions from insuring too many bonds from a single source and will consider a number of different factors, including who originates the bonds and who services the debt. 
 
The Paterson administration said it would also limit insurers in guaranteeing collateralized debt obligations. 
 
Eric R. Dinallo, the New York State insurance superintendent, said that “the severity of this crisis was substantially increased by what the government chose not to regulate, principally credit-default swaps.” 
 
“We are providing an appropriate way for those with an insurable interest to protect themselves,” he said “and we are going to ensure that whoever sells them that protection is solvent, in other words, can actually pay the claims.” 
 
He added: “We will urge the federal government that there should be some sort of national regulatory system that manages credit-default swaps.” 
 
Tomasz Piskorski, an assistant professor of finance and economics at the Columbia Business School, said, “It’s a good idea to bring some light to this market, to impose some rules, some transparency and some standardization of the contracts and increase the likelihood that these contracts will be honored.” 
 
Mr. Piskorski said he did not favor many types of regulation, including the recent ban on some short-selling, but added that “this is one instance where it would be good to get some involvement of the federal authorities to draft some good rules.”