Should CDS be regulated like insurance?
Arthur Kimball-Stanley published a fascinating op-ed on Credit Default Swaps in the Providence Journal on Monday. I spoke with the author and he gave me permission to republish his piece in its entirety. A 30-page version of this argument was accepted for publication in a law journal to be published this fall. The author gave me a recent draft, though the article below offers the essential elements of the argument. Hopefully it gets traction……
Dissecting a Strange Financial Creature
by Arthur Kimball-StanleyHARTFORD
LAST MONTH, Bear Stearns had to be rescued by J.P. Morgan Chase after reportedly booking billions of dollars in credit-default swap (CDS) bets that it was unable to pay. Federal legislators have now decided to give credit-default swaps, one of the most popular derivative contracts traded on Wall Street, the attention they deserve. For those thinking about how the CDS market should be controlled, the most analogous example can be found in insurance law.
What are credit-default swaps? The New York Times’s Gretchen Morgenson describes them as “insurance contracts.” Morgenson writes: “In a [CDS], two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.”
Most law-school contracts professors couldn’t do a better job. Yet, the description leaves out one small but important detail. Insurance regulators don’t — at least not right now — consider CDS insurance and consequently credit-default swaps are not regulated as insurance. In fact, credit-default swaps are not regulated by anybody.
Bill Clinton signed the Commodity Futures Modernization Act (CFMA) of 2000 only weeks before leaving office. Among other things, the act kept the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) from exercising jurisdiction over the then-fledgling derivatives trade between financial institutions, known as the over-the-counter derivatives market. The law took those regulators that were watching the growing derivatives market and told them to look away and laissez faire.
Financial-market regulation in the United States can be broken into four spheres. There is the SEC, which everyone knows regulates standard securities, such as stock and bonds. Then there is the CFTC, which, as its name implies, regulates the trading of pork bellies in May or oranges in January. The third sphere consists of bank regulators, which range from the Federal Reserve Board and the Federal Deposit Insurance Corporation (FDIC) to local state banking authorities. Finally, there are insurance regulators, who operate almost exclusively on the state level. It’s the banking sphere, specifically the Federal Reserve Board, which many think will take on regulating credit-default swaps. The insurance regulators decided they didn’t want the job.
Six months before the CFMA became law, the New York State Insurance Department decided that it wasn’t going to regulate credit-default swaps. The decision in New York mattered because that is where almost all the credit-default swaps in the United States are traded. The contracts have no insured interest or indemnification requirements, lawyers for New York opined. Thus, credit-default swaps could not be defined as insurance.
What’s insured interest or indemnification? Both are part of a group of legal doctrines developed during the 18th Century in England to keep insurance from being used inappropriately. During the 18th Century, the British insurance market was much like the over-the-counter derivatives market today. It was big, profitable, cutting edge (the idea that risk could be calculated was brand new) and unregulated. London insurers wrote policies on many things and for anyone. Merchants bought insurance to hedge against the risk of their ships sinking. And sometimes they bought insurance to speculate on whether or not someone else’s ship would sink.
The problem was obvious. Insurance contracts used to protect against the loss of property owned by the person buying the policy helped the buyer eliminate the consequences of calamity. Insurance contracts used to bet on whether or not calamity would befall someone else’s property not only let the buyer place a bet, it gave the buyer incentive to make that calamity occur, to destroy the insured property he did not own, to sink the other guy’s ship, in order to collect on an insurance contract.
In 1746, Parliament passed the Marine Insurance Act, requiring anyone seeking to collect on an insurance contract to have an interest in the continued existence of the insured property. Thus was born the insured-interest doctrine. The indemnity doctrine, which precludes a buyer from insuring property for more than it’s worth, soon followed. The point of these rules is to limit insurance contracts to trading existing risks and not to create new risks by giving buyers of insurance incentive to destroy property. The doctrines have been part of insurance law in both England and the United States (which in 1746 were colonies under English common law) ever since.
The insured interest and indemnity doctrines are a form of public policy regulating the uses of contracts that transfer risks for a fee, the uses of insurance. They should not be used as a way of defining what is and what is not insurance. A better test of what insurance is asks if the service being provided is the transfer of risk for a fee. If it is, then it’s insurance.
Insurers in New York State successfully lobbied to codify the idea that credit-default swaps are not insurance in 2004, arguing that putting it in the statutes would only make official what the regulators had already decided. The decision by New York regulators to turn a blind eye to the CDS market allowed the underlying value being traded with credit-default swaps to grow to over $45 trillion. This is 10 times the value of the credit obligations that CDS contracts reference, according to University of Texas Professors Bernard Black and Henry Hu. This disproportion results from the use of credit-default swaps not only as insurance but also for speculation. This wouldn’t be possible if credit-default swaps were considered insurance and an indemnity or insured-interest requirement were applied.
Some think that credit-default swaps might have helped bring down Bear Stearns in another way. One of the broker-dealer’s biggest businesses was running operations for hedge funds and other big-volume traders. Those funds started withdrawing their business en masse after bad news about Bear Stearns began to spread, severely hurting the firm’s liquidity. Did those hedge funds try to profit from CDS bets that Bear Stearns would go bust by precipitating a stampede of business from the firm? Such activity is precisely what Parliament worried about in 1746.
Insurance regulators do a pretty good job. They have years of experience at getting rid of the perverse incentives that unregulated insurance can create. They are also good at making sure that those who sell insurance have the money to pay up on the policies they write. Bear Stearns would have never been able to take on the risk it did with credit-default swaps if insurance regulators had been watching. This is also true of Bear Stearn’s presumptive savior, J.P. Morgan Chase, which some analysts are saying has taken on more risk using credit-default swaps than it can handle.
Legislators with the free-wheeling CDS market on their radar could choose a very simple solution. They could simply define credit-default swaps as insurance. If Washington creates an Office of Insurance Oversight — as the Treasury Department has proposed — the first order of business might be to develop rules for the $45 trillion insurance business known as the CDS market. An insured-interest or indemnity requirement, or both, might be a good place to start.
Arthur Kimball-Stanley, now a student at the University of Connecticut Law School, is a former reporter for Dow Jones and The Providence Journal.