New York State Insurance Superintendent Eric Dinallo spoke at a hearing here today about coming up with a “holistic” approach to regulating the credit default swaps market.

A credit default swap is an over-the-counter contract that gives the buyer the right to collect a payment from the seller if a borrower defaults on the terms of a bond, note or other debt security.

Dinallo told members of the Senate Agriculture Committee that credit default swaps can be divided into two categories.

The first category includes transactions in which the holder of an obligation, such as a bond, “swaps” the risk of default with another party for a fee.

That type of transaction resembles an insurance transaction, Dinallo said.

The second category of credit default swaps includes “naked credit defaults swaps,” Dinallo said.

When parties set up a naked credit default swap, neither party owns the bond, note or other obligation linked to the swap, Dinallo said.

In effect, Dinallo said, a naked credit default swap is a bet on whether the issuer of the obligation will default.

Dinallo noted that the Commodity Futures Modernization Act, passed in 2000, created a “safe harbor” for credit default swaps.

The CFMA safe harbor preempted state laws that would have barred credit default swaps and exempted credit default swaps from regulation by the Commodity Futures Trading Commission, Dinallo testified.

Also in 2000, someone asked the New York Department of Insurance a “very carefully crafted question” about whether the department would treat naked credit default swaps as insurance contracts.

“Clearly, the question was framed to ask only about naked credit default swaps with no proof of loss,” Dinallo said. “Under the facts we were given, the swap was not ‘a contract of insurance’ because the buyer had no material interest and the filing of a claim does not require a loss. But the entities involved were careful not to ask about covered credit default swaps. Nonetheless, the market took the department’s opinion on a subset of credit default swaps as a ruling on all swaps and, to be fair, the department did nothing to the contrary.”

The CFMA safe harbor provision and the swaps market participants’ reading of the New York department guidance let the credit default swaps market go unregulated by state insurance regulators or by the U.S. Commodity Futures Trading Commission, lawmakers and witnesses said at the hearing.

Because credit default swaps are not traded on “open, transparent exchanges … it is literally impossible to know whether swaps are being traded at fair value or whether institutions trading them are becoming over leveraged or dangerously overextended,” said Sen. Tom Harkin, D-Iowa, the chairman of the Senate Agriculture Committee.

Current estimates suggest that the credit defaults swaps market has a total face value of about $62 trillion, which is about the same as the world’s 2008 gross domestic product.

Hearing participants talked about the idea of creating an exchange or clearinghouse to get a hold on the market.

Some witnesses said there are legitimate reasons to set up “naked swaps.” Those witnesses objected to the idea of banning naked swaps outright.

Richard Lindsey, president of the Callcott Group L.L.C., New York, responded to Harkin’s characterization of swaps as “casino capitalism” by contending that swaps have some similarities to futures contracts.

“While credit derivatives are often pejoratively described in the media as a ‘bet,’ it is important to realize that one could equally describe all investments as ‘bets,’” Lindsey said.

Dinallo testified that naked swaps can help companies hedge against exposures that are not directly related to their own operations.

A company could, for example, use credit default swaps to protect against the risk of a downturn affecting a large customer’s ability to pay its bills, Dinallo testified.

Lindsey said the best solution for ensuring that credit default swaps are conducted responsibly is to make sure that the executives at the companies involved know what they are doing.

At a company involved with credit default swaps, “each individual has a duty to probe, to challenge and to ensure that he or she has confidence in and understands the answers,” Lindsey said.