A New CDS Loophole Compliments of the CFTC

By | May 2, 2011

Maybe I’ve spent too many months of reading regulatory proposals and legislation, or maybe I’ve just grown pessimistic, but it seems a CDS loophole exists in the otherwise mundane definition of “swap” released by the CFTC on April 27th.

The CFTC fact sheet on the proposal tells us that consumer and commercial transactions, loan participations, some forwards and insurance contracts are not swaps. That makes sense. But reading into the definition of insurance made me stop and think – if you take out point 4 (below), doesn’t this sound very much like a covered credit default swap (CDS)? My comments in parentheses:

1. (must own the bond) the beneficiary must have an insurable interest that is the subject of the contract and thereby bear the risk of loss with respect to that interest continuously throughout the duration of the contract;
(the underlying has a credit event) the loss must occur and be proved;
(the notional of the bonds held) any payment or indemnification for loss must be limited to the value of the insurable interest;
(I’ll get back to this) the contract must not be traded, separately from the insured interest, on an organized market or over-the-counter; and
(contract terms are up to the dealer) with respect to financial guaranty insurance only, in the event of a payment default or insolvency of the obligor, any acceleration of payments under the policy must be at the sole discretion of the insurer.

The CFTC also requires in its proposal that the company selling the credit protection – I mean insurance – must be an insurance company. OK, so taking all of that into account this is where I see the loophole.

An insurance company, let’s say AIG for no particular reason, works with a large asset manager who wants to hedge the credit risk on its bond holdings. A custom credit default swap is created that cannot be traded openly (just like, say, car insurance). The asset manager can only get out of the contract by terminating or holding to maturity. And in compliance with the rest of the points above, the beneficiary has an insurable interest (the bond), a loss (a credit event) if incurred could be proved, the contract is written for the value of the insurable asset (the bond) and the insurer has discretion over acceleration of payments under certain circumstances.

That all equals a custom CDS that falls outside of all OTC derivatives regulation.

You might argue that this was still “traded” over the counter, violating point four above; but why is this any different than me buying homeowners insurance from my local insurance company? I’m not “trading” when I do that, I’m just buying insurance.

The fact that this transaction as I describe it cannot be naked does reduce the counterparty risk somewhat – the notional of contracts written cannot outnumber the notional outstanding of the actual bond, hence no leverage. However, the asset manager that believes it is perfectly hedged by the contract is still at the mercy of the insurance company’s ability to pay. The insurance company is out of the jurisdiction of the SEC and CFTC and insurance regulators have no experience (or business) regulating financial derivative contracts; hence, potential systemic risk and limited transparency.

Is this whole scenario a stretch? Maybe, but with an industry looking for new ways to profit as old ones have been regulated out of existence, nothing is off the table.

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