Former FDIC Chairman Sheila Bair admonishes insurance regulators to treat CDS products like insurance, but is the industry listening? by Bill Gee
(centrist)
Friday, December 9, 2011
On November 3rd of this year I had the pleasure of attending the National Association of Insurance Commissioners (NAIC) meeting in Washington DC. For those of you who don’t know, the NAIC is the nationally recognized regulatory body that oversees the insurance industry – everything from Health & Life Insurance to Property & Casualty to Reinsurance.
The insurance industry is not like any other type of regulated industry in this country in that the states have primary regulatory control of insurance companies and not the Federal Government. This is due to an 1868 Supreme Court ruling that essentially said that insurance contracts were not the same as commercial contracts and therefore were not subject to interstate commerce laws. (This is important, and we’ll get back to this point later)
Following the 1868 ruling, (reversed in 1944 but not before the wheels were already set in motion) individual states started regulating insurance companies within their individual states. In order to come up with a semi-uniform set of rules and regulations, the NAIC was created in 1871. How the NAIC works is that they gather together the state regulators from all over the country and they discuss and make recommendations for new rules and regulations for the insurance industry as a whole, and the individual states tend to adopt their recommendations. Some states have additional rules that insurance companies licensed within their borders must follow, but almost all of the states see NAIC rules as the minimum.
Sheila Bair
Although she had nothing to do with the insurance industry in her tenure as chairman of the Federal Deposit Insurance Corporation (FDIC), Sheila Bair was invited to the Fall NAIC meeting to give the Keynote Address at its opening session. The reason why she was invited to the meeting is because of her crusade to convince the insurance industry to lobby the states to regulate the Credit-Default-Swap market as an insurance product, and not as a financial services product.
This is hardly surprising because in all of her years as a banking regulator, she has pushed hard for a more robust regulation of the financial services industry, especially the so-called Derivatives Market. What she believes should be of particular interest to the insurance industry is the regulation of Credit-Default-Swaps.
Credit-Default-Swaps
Let’s make no bones about it. Swaps are insurance, but they are not regulated like insurance. Instead they’re regulated the same as stocks, bonds, options and other financial instruments that investors and the top 1% use to improve their investment portfolios.
For those of you who don’t know, this is how they work. But in order to do this, we’ll have to turn back the clock to 2005.
Let’s say it’s 2005 and you own $100 million worth of Sub-Prime Mortgage-Backed Securities (MBS) and you’re afraid that sometime in the next few years, they may not be worth the paper they’re printed on as homeowners start defaulting on their mortgages like crazy. (Sounds nuts, but it could happen!) You tell your broker at Goldman Sachs that you want to take out some insurance on your bonds that would pay you the value of the security should they start to default and/or lose their value due to foreclosures. Goldman comes back to you with a cheap insurance product from AIG called a Credit-Default-Swap that does just that, except that it’s not technically an insurance product.
Why CDS Contracts are NOT Insurance
It’s not technically an insurance product because of the jurisdiction issue (see paragraph #2 above). MBS bonds are not state-specific because they can consist of hundreds or even thousands of different mortgages from all over the country. Therefore, there is no way for state regulators to evaluate and/or license a CDS contract. As such, CDS contracts didn’t need to have the same reserve requirements that state-regulated insurance contracts must have.
Since CDS Contracts were not technically insurance products, AIG had no problem selling them to anyone who asked for them, even investors who didn’t own any MBS bonds, but were betting on their belief that the MBS bond market was going to collapse.
When the financial crisis hit in 2008, it wasn’t the fact that people were losing their homes that nearly destroyed the economy, it was the fact that AIG and other financial services companies like Bear Sterns and Lehman Brothers were left holding the bag on CDS contracts that were worth five to six times more than the MBS contract they were insuring! And if it wasn’t for the Troubled Asset Relief Program (TARP), which used $700 billion in taxpayer money to bail out the banks it would have done just that.
CDS Contracts ARE Insurance
Aside from the obvious reasons, Credit-Default-Swaps are insurance and should be regulated as such, but it’s going to take some work on the part of the NAIC to make it happen, which was the point the former FDIC Chairman was trying to make in her keynote address. Below are some of the key provisions that I believe can and must be done by the NAIC.
1) They can clearly define what a CDS contract is, and establish industry guidelines on the exact wording that should appear in every CDS contract.
2) They can establish minimum reserve requirements. (The insurance industry calls this “Surplus” but it’s essentially the same thing) Every insurance contract signed in this country is bound by reserve requirements, and CDS contracts should be no exception. The minimum reserve requirement on your auto or home policy is 10% (that is, ten cents of every dollar of premium collected is set aside for the payment of claims), but due to the catastrophic impact a CDS trigger event would have on the economy as a whole, I would suggest putting the reserve requirement at 20 - 25%.
3) They can prohibit the trading of CDS contracts. If you allow your neighbor to buy an insurance policy on your home, they then have a financial incentive to see it get burned to the ground. Selling a CDS contract to someone who doesn’t own the insured security has the same incentive to see that bond fail. Therefore, CDS contracts should only be sold to the investors who actually hold the bond being insured.
4) They can limit the sale of CDS contracts only to MBS bonds that are limited by geographic region and that are more transparent. One of the reasons why CDS contracts are so hard to regulate is because actuaries at insurance companies have such a difficult time evaluating the risk associated with the underlying security. If MBS bonds consisted of properties within a particular insurance jurisdiction, and the properties themselves were clearly identified by risk location, actuaries can better create risk models in order to appropriately price CDS contracts, and provide regulators with the appropriate level of assurance that the companies issuing the contracts have reserved appropriately.
Is Anything Going to Happen?
Sadly, the NAIC has a lot on their collective plates at the moment, so for now they are showing very little interest in taking on the CDS industry. In fact, if I hadn’t actually been in the audience of the NAIC Opening Session, I would have had no clue that Sheila Bair had spoken so thoughtfully and forcefully on the subject, because the text of her speech was not published anywhere although her views on the subject are widely known.
With the failure of the Wall Street Reform and Consumer Protection Act of 2010 (aka Dodd-Frank) to address the Derivatives Market, and Congress’ unwillingness to cut short their sugar-daddies, it will probably take yet another major financial crisis before the insurance industry decides to take decisive action on this issue.
Let’s just hope that next time there will be an industry to regulate after the dust clears.
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