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Finally! A start to solving the CDS problem. New York Governor Paterson, together with Insurance Superintendent Dinallo, announced that the state will regulate credit default swaps as insurance when there is an insurable interest underlying the transaction. Here is a link: http://www.ins.state.ny.us/press/2008/p0809224.pdf. The announcement is well worth reading in its entirety: it provides a great deal of clarity about the serious issues that remain for the SEC to address.
This is another serious embarrassment to the SEC, as a state regulator has been forced to extend his own jurisdiction in order to compensate as much as possible for the serious omissions of Federal oversight. The announcement encourages the SEC to step up to the plate and regulate credit default swaps that are not insurance - ie., "naked swaps."
The purchase of a credit default swap, when the buyer does not own the referenced debt, is in point of fact euivalent to a naked short sale of the bond. The announcement explains: "... just as with short selling of stock, most swaps are now used by speculators who do not own the bonds and the value of swaps outstanding are generally much more than the value of a company's debt. Swaps bought by speculators are known as "naked swaps" because the swap purchasers do not own the underlying bond. Speculation in a company's bonds can under some
circumstances hurt that company's ability to borrow."
To quote Dinallo: "The severity of this crisis was substantially increased by what the government chose not to regulate, principally credit default swaps.This is primarily a credit crisis, not an equity crisis, and that is where the focus should be now."
The point is, the SEC needs to halt the sale of naked swaps immediately, as they are causing far more of the problem than the activities of legitimate short-sellers. Thes is the same issue I have been referring to as the moral hazard caused by credit default swaps.
This will be good news for Ambac (ABK) and MBIA (MBI), as they will now be able to provide insurance on corporate bonds without competition from unliclensed, unregulated and potentially irresponsible market participants.
Watch for an announcement from the SEC. When that appears, the crisis is over.
PS After this was posted SEC Chairman Cox asked Congress for authority to regulate CDS. It turns out that Congress blew the call in 2000 with the Commodity Futures Modernization Act, which barred the CFTC from regulating credit-default swaps. Already smart lawyers are asserting Cox has no authority even to investigate fraud or manipulation in connection with CDS.
Cox was very careful in his testimony at the Senate hearing today to point out that the buying of "naked swaps," those that are not supported by an insurable interest, is in point of fact a naked short sale of the underlying bond. It has huge leverage and very little downside risk. Cox further notes that the amount of CDS purchased frequently is greater than the total amount of bonds outstanding.
So now what is needed to to write your congressman to pass a law to enable the SEC to regulate these contracts. I now think that naked swaps are gambling contracts, and as such illegal per se.
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