Regulators push for oversight of credit swaps

Calls for government oversight of credit default swaps are growing, with state and federal officials pinning part of the blame for the current financial crisis on the market for these complex investments.

During testimony on Capitol Hill Tuesday, Securities and Exchange Commission Chairman Christopher Cox urged Congress to begin regulating the market for CDSs, or swaps, which are complex insurance and derivative contracts.

CDSs have played a prominent role in the mushrooming credit crisis that in the past week led to the bankruptcy filing of Lehman Brothers Holdings Inc., a government rescue plan for insurer American International Group Inc. and Merrill Lynch & Co. selling itself to Bank of America Corp.

The market for CDSs is huge: $62 trillion. While little known to many individual investors, they are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they are also bought and sold as bets against bond defaults — a buyer doesn't necessarily have to own a bond to buy the CDS that insures it.

The sheer volume of CDSs sold by AIG coupled with rising levels of defaulting mortgage and other debt threatened the existence of the nation's largest insurer, and forced the government to bail it out to avoid a catastrophic collapse. If AIG were to fail, its losses would spread to the companies and investors who bought swaps from them.

Cox's testimony calling for the regulation of the the swaps market cames a day after state regulators in New York said they will begin in January to oversee the portion of the market in which the buyer of a CDS actually owns the bond or debt. Such cases are akin to a homeowner buying insurance to protect the asset.

New York State Insurance Superintendent Eric Dinallo said Monday the state will begin regulating these CDSs in 2009.

"Such swaps would be subject to regulation for the first time and can thus only be issued by entities licensed to conduct insurance business," Dinallo said in a statement.

This new regulation would for the first time force banks and other financial institutions to apply to become insurers in New York if they want to sell swaps. Dinallo said it will help protect buyers of the swaps because insurers will be required to have enough reserves to cover potential claims on the contracts.

With the swaps still unregulated, financial firms selling them do not need to have minimum reserves to protect against losses.

What is deemed the riskier, and likely larger portion of the swaps market, is where buyers of insurance do not actually own the underlying bond or debt. In this case, investors use swaps to essentially place bets on a company's performance, similar to shorting a stock — the move is purely speculative, as the investors are betting only on whether a bond or security will be paid off or fail.

This second type of swaps will remain unregulated by the state of New York, but could be regulated federally if Congress acts on Cox's calls to add the oversight of the financial swaps to a broader financial regulatory overhaul.

However, that regulatory overhaul is unlikely to even be discussed until next year.

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AP Business Writer Jeannine Aversa in Washington contributed to this report.