OLR Research Report

December 10, 2008




By: Janet L. Kaminski Leduc, Senior Legislative Attorney

You asked for information on: (1) a type of derivatives called credit default swaps (CDS), (2) collateralized debt obligations (CDO), and (3) New York's proposal to regulate the CDS market.


Derivatives are financial contracts whose values are derived from the value of an underlying asset (e.g., commodities, stocks, residential mortgages, bonds, loans). A credit derivative is based on loans, bonds, or other forms of credit. There are three main types of derivatives: forwards (or futures), options, and swaps. Credit default swaps (CDS) and collateralized debt obligations (CDO) are both types of derivatives.

Derivatives can be used to “hedge” or mitigate the risk of economic loss arising from changes in the value of the underlying item. Investors can also use them to “speculate” or increase their profit should the value of the underlying item move in the direction they anticipate.

A CDS is a privately negotiated derivative through which a “buyer” pays an agreed-upon amount to a “seller” and, in return, receives a payment if a certain event occurs (e.g., the underlying financial instrument defaults). The buyer does not need to own the underlying security and does not have to suffer a loss from the event in order to receive payment from the seller. Thus, CDS can be used for speculating

(“naked CDS”) or hedging (“non-naked CDS”). And buyers and sellers can swap their contracts with others, though there is no oversight or transparency mechanism for the swaps.

A CDO is a financial tool that bundles individual loans into a product that can be sold on the secondary market (those who purchase an interest in a loan from an original lender, such as banks or institutional investors). The product is called an “asset-backed security” if the loans are corporate debt, and “mortgage-backed security” if they are mortgages.

The CDO market has been implicated in the current economic downturn, including the collapse of the housing market. For example, Bear Sterns reportedly had unprecedented losses in 2007 due to the decline in value of its CDO holdings backed by subprime mortgages. The CDS market also has been tied to the current economic downturn (e.g., Lehman Brothers and AIG were parties in a large number of CDS transactions). As a result, the Treasury secretary and chairs of the Commodities Futures Trading Commission, the Federal Reserve Board, and the Securities and Exchange Commission are working to effect change that would make CDS transactions more transparent and add oversight to the derivatives market.

Meanwhile, the New York Insurance Department issued Circular Letter No. 19 (2008) outlining “best practices” for financial guaranty insurance companies (FGIs) that insure certain securities, including non-naked CDS (i.e., CDS buyers using the product to protect against losses in instruments they own). According to the circular, FGIs “should restrict significantly” the issuance of policies insuring CDOs consisting of asset-backed securities. Such policies should not be issued unless they meet specified criteria. The department plans to formalize the best practices in regulations and, to that end, held a public hearing on December 5, 2008.


A CDS provides insurance-like protection against the possibility of a default. It is a contract through which a buyer pays money (a premium) to a seller who agrees to pay the buyer a certain amount (a settlement) if a specified event occurs (e.g., a financial instrument defaults). The contracts can be traded, or swapped, between investors. Both buyers and sellers can trade their CDS contracts to others.

A CDS buyer can be anyone who can legally enter a contract and wants to add this to a financial portfolio. A person or entity may or may not have an interest in the underlying financial instrument to be a buyer. Rather, a buyer can enter into a CDS to hedge financial risk or to profit on speculation that the instrument may fail. Banks, hedge funds, and other security firms are typical CDS sellers.

There is broad consensus that CDS is not insurance because the buyer does not need to own the underlying financial instrument and does not have to suffer a loss from the default in order to receive payment from the seller. When the specified event occurs, the seller settles with the buyer according to the contract terms. The amount of loss the buyer suffers, if any, is irrelevant.

The face value of outstanding CDS contracts worldwide was $62 trillion at the end of 2007 and $54.6 trillion on June 30, 2008 (compared to $900 billion in 2000), according to the International Swaps and Derivatives Association (ISDA) and reported in Fortune Magazine at CNNMoney.com (accessed December 8, 2008 at (http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/index.htm). The article says the $54.6 trillion value of CDS contracts “completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt.”

The ISDA has developed a document template to capture terms of a CDS (called a “confirmation”). It has helped standardize terms and terminology, which allows transactions to be completed quickly. According to the cited article, a CDS contract can be set up in a one-minute telephone call or an instant message.


The federal Commodity Futures Modernization Act of 2000 (PL 106-554) appears to (1) make CDS activity legal and (2) remove them from federal regulatory oversight. It (1) exempts CDS from regulation as futures, (2) considers them to be “security-backed swaps” subject to the anti-fraud and anti-manipulation provisions of the federal Securities Act of 1933 and the Security Exchange Act of 1934, and (3) prohibits the Security and Exchange Commission from taking preventive measures against fraud or manipulation with respect to security-backed swaps.


ISDA represents participants in the privately negotiated derivatives industry. It has approximately 850 member institutions from 56 countries, including most of the world's major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities, and others that rely on such derivatives to manage the financial market risks in their core economic activities.  Information about ISDA is available at www.isda.org.


A CDO is a financial tool that bundles individual loans (e.g., mortgages, auto loans, credit card debt, corporate debt) into a product that can be sold on the secondary market. The product is called an “asset-backed security” if the loans are corporate debt and “mortgage-backed security” if they are mortgages. (If the mortgages are made to people with less than a prime credit history, they are called “subprime mortgages.”)

Selling CDOs is a way for companies to increase their liquidity. For example, a bank might sell debt (i.e., a group of mortgages) to obtain capital to invest (e.g., make more loans). An investor buying the CDO does not necessarily know what assets are included in the instrument.

There are numerous CDO types, each based on the underlying asset (e.g., loans, fixed income securities, real estate, reinsurance contracts). A structured finance CDO, or SFCDO, is backed primarily by structured products like asset-backed and mortgage-backed securities. Collateralized synthetic obligations, or CSO, are backed primarily by credit derivatives like CDS.



Financial guarantee insurance companies (FGIs) issue insurance policies on two main types of securities: municipal bonds and asset-backed securities. Through such policies, FGIs have helped reduce borrowing costs for issuers of debt instruments for over 35 years, according to the New York Insurance Department. But in recent years, FGIs began insuring more risky non-government structured securities, including CDOs backed by asset-backed securities (“ABS CDO”), and CDSs entered into

with banks and security firms. If a party to a CDS fails to make payment when the credit event specified in the contract occurs, the FGI has to make payment, even though the credit event may have been outside the scope of risks that an FGI policy can guarantee.

With declining home values, many FGI policies involving CDO and CDS are incurring losses, triggering FGIs to pay claims and national rating companies (e.g., Moody's) to downgrade the FGIs.

Current State Regulation

Most FGIs in the United States are located or licensed in New York, making its Insurance Department the primary regulator of U.S. FGIs through Article 69 of the New York Insurance Law. New York law includes requirements intended to safeguard the financial solvency of FGIs authorized to do business there, including: minimum capital, surplus, and contingency reserves; aggregate and single risk limitations (i.e., limits on the amount and type of securities it may insure); and limitations on the non-investment grade securities an FGI can insure.

Best Practices Effective January 1, 2009

The New York Insurance Department outlined “best practices” that it expects FGIs to follow, beginning January 1, 2009, in Circular Letter No. 19 (2008), issued September 22, 2008, (copy enclosed), which is available at http://www.ins.state.ny.us/circltr/2008/cl08_19.pdf. It intends to promulgate regulations or seek legislation to formalize the guidelines. According to Circular Letter No. 19 (2008), FGIs “should restrict significantly” the issuance of policies insuring ABS CDOs. Such policies should not be issued unless they meet certain criteria, such as only insuring more secure securities (e.g., those issued or guaranteed by a government-sponsored enterprise).

On November 20, 2008, the department issued a supplement to the circular, in which it stated that it is delaying indefinitely the application of New York Insurance Law to CDS as described in the circular. The department cited progress made toward federal regulation of CDS as the reason. But the supplement does not change the department's plan to implement best practices for FGIs to follow effective January 1, 2009. The supplement (copy enclosed) is available at http://www.ins.state.ny.us/circltr/2008/cl08_19s1.pdf.

The department held a public hearing regarding potential regulation of FGIs with respect to CDS on December 5, 2008. The public hearing notice said, beginning January 1, 2009, the new rules:

1. require entities engaging in the business of CDS to be licensed;

2. increase the amount of financial reserves FGIs must maintain in order to engage in certain CDS transactions;

3. limit the types of investments that FGIs can insure;

4. increase accounting and reporting standards to allow the department greater oversight; and

5. restrict aggregate investment portfolios to investment-grade securities or better.

The rules apply with respect to non-naked CDS (i.e., buyers using CDS to protect against losses in instruments they own), which may arguably be considered insurance.