On September 22, 2008, New York Governor Paterson announced that New York will soon begin regulating certain credit default swaps (CDS) as insurance contracts. According to the announcement, a credit default swap is insurance when it is used by the owners of bonds to protect themselves if the issuer is unable to pay interest and principal because, in those cases, "the swap buyer is like a homeowner insuring a home."

The announcement referenced Circular Letter 19 (2008), which was issued by the New York Insurance Department on the same day as the Governor's announcement. The Circular Letter expresses the Department's concerns regarding how financial guaranty insurance companies (FGIs) have conducted their businesses and outlines "'best practices' to which the Superintendent, on a prospective basis, expects FGIs to adhere, beginning January 1, 2009."

In the Circular Letter, the Department advised that "the making of the CDS itself may constitute 'the doing of an insurance business' within the meaning of Insurance Law §1101" when "it is purchased by a party who, at the time at which the agreement is entered into, holds, or reasonably expects to hold, a 'material interest' in the referenced obligation." Thus, New York does not aim to regulate so-called "naked" CDS. The Circular Letter, however, effectively reverses a prior ruling by the Department in 2000 in which the Department  concluded that "all credit default swaps were not insurance."

The Department indicated that an opinion to be prepared by the Department's Office of General Counsel would be issued to clarify the Department's position that certain CDS constitute insurance. The Department also advised protection sellers to seek "an opinion from the Department's Office of General Counsel to assess whether the protection seller should be licensed as an insurer pursuant to Insurance Law §1102."

Protection sellers required to be licensed with the Department would be licensed as FGIs under Article 69 of the New York Insurance Law, which sets forth a series of specialized and highly technical requirements intended to safeguard the financial solvency of FGIs authorized to do business in the State. In addition, such

protection sellers would be required to comply with the Department's newly issued 'best practices' guidelines in the Circular Letter, which, among other provisions:

  • Limit the structures that can be covered by policies issued by FGIs, including restrictions on the issuance of CDS with respect to multi-tranched obligations, known as "CDO squareds."
  • Restrict FGIs' "participation in the CDS market to those transactions in which the insurers' risk is roughly comparable to the amount and timing of risks assumed when directly insuring bonds."
  • Require FGIs, in considering concentration risk, to "include not only the issuer of the debt, but also the initial lender and servicer of each category of obligation (such as consumer debt obligations or obligations secured by residential real estate), regardless of the type of underlying collateral."
  • Require that at least 95% of an FGI's insured portfolios be investment grade.
  • Require FGIs to develop and implement underwriting procedures, managerial oversight methods, investment policies, and such other matters as may be prescribed by the Superintendent.

The Department intends to seek a change in the New York Insurance Law governing FGIs to increase the amount of paid-in capital from at least $2,500,000 to at least $15,000,000, and paid-in surplus from at least $72,500,000 to at least $165,000,000. In addition, the Circular Letter states that the Superintendent "expects" FGIs that issue policies on certain junior tranches of asset-backed securities to maintain higher minimum levels of capital and surplus than ordinarily required under current law in order "to account more accurately for the higher risks associated with the guaranty of junior tranches." The Department also intends to increase the reporting requirements for FGIs and to step up its target examinations of such entities.

The Department stated that it will seek legislation or adopt new regulations to implement the best practices set out in Circular Letter 19.