On November 3, 2011, Sheila Bair, former Chairwoman of the Federal Deposit Insurance Corporation (“FDIC”), in a speech to attendees of the national fall meeting of the National Association of Insurance Commissioners, focused on systemic risk posed by credit-default swaps on the United States financial system.  Chairwoman Bair told the audience of insurance regulators and industry representatives that the credit-default market is still “highly concentrated” and “poses very serious systemic risks.”

Credit default swaps are generally considered to be similar to credit insurance, in that they allow purchasers to be compensated in the event that a given loan defaults.  But, according to Bair, there is a very importance difference between the two; there is no need for an insurable interest for the buyer of credit default swaps.

According to Bair, “[b]ecause the buyer [of credit default swaps] receives money when the loan defaults, they have an incentive for those loans to default.  For that same reason, we don’t allow just anyone to take out a life insurance policy on someone because they would have an incentive for that person to die.  Just like we don’t allow people to buy fire insurance for a neighbor’s home because they would have an incentive for that person’s house to burn down.”

Under Bair’s rationale, the lack of an insurable interest requirement in the purchasing of credit default swaps is what magnified the losses on the underlying mortgages.  Bair stated that, “[w]e probably could have handled the underlying mortgage losses that set off the financial crisis [of 2008].  But it was the way the losses on those mortgages were magnified by these CDS and the fact that they were unregulated that caused the real problem.”  Therefore, according to Bair, “[m]uch of the problem could have been avoided if we had more regulation of CDS and had more insurance regulation of CDS.”

Further, Bair said that since insurance regulators have experience regulating insurance products that are similar to credit default swaps, they can provide valuable insight to regulators of derivatives.