On September 22, 2008, the New York State Insurance Department ( the “Department”) announced in revised Circular Letter No. 19 (2008) ( the “Circular Letter”) a series of “best practices” for financial guaranty insurance companies (each a “FGI” or, collectively, “FGIs”) which provide insurance or “wraps” for municipal bonds or asset-backed securities (“ABS”) through either credit default swaps (each a “CDS”, or collectively, “CDSs”) or financial guaranty policies. The Department expects all FGIs subject to the Department’s oversight to follow these guidelines on a prospective basis beginning on January 1, 2009 and will promulgate regulations or seek legislation, as necessary, to formalize these guidelines.

In addition to imposing increased capital and surplus requirements, additional reporting obligations and stricter risk management standards, the Circular Letter also sets forth new limitations on the ability of FGIs to insure collateralized debt obligations (“CDOs”) supported by ABS. In particular, FGIs 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. Also, a FGI 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 above; (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 FGI; or (iv) the Superintendent of the Department determines that “the insurance is without undue risk to the FGI, its policyholders, and the people of the State of New York.” 

The Department has also issued new guidelines which are designed to confine participation by a FGI (via a financial guarantee policy of the obligations of a wholly owned subsidiary) in the CDS market to transactions with respect to which the risks of the FGI as to the amount and timing of any payments is similar to the risks the FGI would bear if it directly insured the debt obligation referenced in the relevant CDS transaction. Specifically, the Department expects FGIs to discontinue the issuance of policies related to CDSs 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 FGI issuing the policy; and (iii) neither the CDS nor the related policy requires the FGI to post collateral.

The most significant aspect of the Circular Letter is the Department’s apparent change of position with respect to the circumstances under which a CDS may constitute an “insurance contract” and whether the entry into such CDS as a “protection seller” constitutes the “doing of an insurance business”. (In fact, the paragraph addressing this issue did not appear in the version of the Circular Letter dated September 12, 2008). Since June 2000, market participants 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, the payment to the protection buyer “is not conditioned upon an actual pecuniary loss.” However, in discussing CDSs entered into by wholly owned subsidiaries of FGIs, the Circular Letter suggests that the Department may now take the position that a CDS constitutes “the doing of an insurance business” within the meaning of New York Insurance Law § 1101 in instances in which the protection buyer, at the time at which the agreement is entered into, “holds, or reasonably expects to hold, a ‘material interest’ in the referenced obligation.” The Circular Letter states that greater clarification on this point will be provided in a forthcoming opinion from the Department’s OGC.

At a minimum, the Circular Letter has created uncertainty as to whether any entity that sells credit protection under a CDS to a buyer that holds a physical position in the underlying debt obligation or reasonably expects to acquire a physical position in such debt obligation could be deemed to be engaged in the practice of insurance and therefore subject to the regulation and oversight of the Department. Such sudden and sweeping regulation would have a profound impact on the $62 trillion notional amount CDS market.