The New York Insurance Department (the “NYID”) has announced that effective January 2009 it will regulate credit default swaps (“CDS”) as insurance contracts. Institutions selling credit protection under CDS contracts in New York will have to be licensed by the NYID as insurers. The new plan will apply prospectively to CDS contracts under which the buyer owns the bonds referenced in the CDS contract and not to "naked swaps" under which the buyer does not own the referenced security. New York Governor Paterson, in announcing the new position, stated:

"The absence of regulatory oversight is the principle cause of the Wall Street meltdown we are currently witnessing. 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."

New York State Insurance Superintendent Eric Dinallo echoed Paterson's sentiments, saying:

"What New York State is doing fits our role as insurance regulators. We are providing an appropriate way for those with an insurable interest to protect themselves and we are going to ensure that whoever sells them that protection is solvent, in other words, can actually pay the claims. There is currently no such protection for policyholders."

U.S. Securities and Exchange Commission Chairman Christopher Cox also called for regulation when in testimony yesterday before the Senate Banking Committee, he stated that lawmakers should "provide in statute the authority to regulate these products [CDS] to enhance investor protection and ensure the operation of fair and orderly markets." Cox went on to say in his prepared testimony that "neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure," and that such a lack of oversight should be addressed "immediately."

Insofar as the federal government does not regulate insurance, New York has clearly determined to take the lead by regulating the CDS market under its existing insurance regulatory authority. We anticipate that other states will do the same, setting up a potential states versus federal contest for regulation of the CDS market. However, Congress does have the authority, if it determines to do so, to preempt efforts at state regulation.

The introduction of insurance regulation into the CDS market will require sellers of CDS protection to dramatically revise their business model, including economic provision for maintenance of reserves and implementation of significant compliance procedures. It is clear that the plan will result in a fundamental restructuring of the CDS market. However the form that the regulations ultimately take will be critical to market participants, who may want to provide commentary to the NYID.