ALBANY - Governor David Paterson Monday announced that New York State will, beginning in January, regulate part of the credit default swap market which has to date been unregulated and has been a major contributor to the emerging financial crisis on Wall Street. Governor Paterson also called on the federal government to regulate the rest of the massive $62 trillion market.

This action is similar to one recently taken by the federal government that tightly restricts “short selling,” or profiting from falling stock prices. The state action applies to credit default swaps which are a means of profiting from falling values of bonds. Under the direction of Paterson, the New York Insurance Department today issued new guidelines that, for the first time, establish that some credit swaps are insurance and therefore subject to state regulation.

The primary goal of insurance regulation is to protect policyholders by ensuring that providers of insurance are solvent and able to pay claims on policies they issue. The goal of regulating these swaps is not to stop sensible economic transactions, but to ensure that sellers have sufficient capital and risk management policies in place to protect the buyers, who are in effect policyholders. At AIG, for example, insurance companies regulated by the state are required to hold substantial reserves and as a result those companies are solvent and able to pay claims. However, a major part of AIG’s problems were created when credit default swaps were issued by a non-insurance unit that did not hold sufficient reserves.

A credit default swap is similar to a short sale of a stock. In both cases, an investor profits when the value of the security, either a bond or a stock, declines. As part of efforts to contain the current financial crisis, the federal government has temporarily limited some short sales of some stock to prevent destructive speculation that was damaging the health of targeted companies.

Credit default swaps played a major role in the financial problems at AIG, Bear Stearns and the bond insurance companies. A credit default swap is a contract under which the seller promises to pay the buyer if the insurance provider of the bond cannot pay principal and interest. Credit default swaps can be used by the owners of bonds who want to protect themselves if the company that issued the bonds is unable to pay interest and principal. In those cases, the swap is insurance, because the swap buyer is like a homeowner insuring a home. But, just as with short selling of stock, most swaps are now used by speculators who do not own the bonds and the value of swaps outstanding are generally much more than the value of a company’s debt. Swaps bought by speculators are known as “naked swaps” because the swap purchasers do not own the underlying bond. Speculation in a company’s bonds can under some circumstances hurt that company’s ability to borrow.

The new guidelines establish that when the buyer owns the underlying security on which he is buying protection then the swap is an insurance contract. Under these new regulations, such swaps would be subject to regulation for the first time and can thus only be issued by entities licensed to conduct insurance business. So called “naked swaps” are not insurance and cannot be regulated by the State.