NEW YORK (Reuters) - Troubles among U.S. bond insurers are forcing regulators to rethink a 1998 loophole that let an industry expand into the complex and now costly world of derivatives, the Wall Street Journal reported on its Web site Tuesday.
Bond insurers have been clobbered by losses from backing mortgage-related securities, which have plunged in value during the past year. With their financial strength damaged, New York recently worked to broker a rescue plan for insurers involving Wall Street banks who otherwise might face big losses on claims that would no longer be covered.
New York Insurance Superintendent Eric Dinallo and other insurance regulators are considering a legal loophole that let bond insurers issue credit-default swaps through shell companies called “transformers,” the paper reported.
Frustrated by the low-margin business of providing guarantees on municipal bonds, insurers told New York regulators they also should be allowed to underwrite credit-default swaps on mortgage securities.
After New York gave its blessing, other states followed suit and the business of writing credit-default swaps on packages of mortgage bonds soared. Bond insurers wrote swaps on around $100 billion in mortgage securities over the past few years, the paper said.
Insurers set up shell companies under Delaware state law known as “transformers,” because they transformed a traditional bond-insurance contract into a credit-default swap.
LaCrosse Financial Products LLC was the transformer for MBIA Inc (MBI.N), while Ambac Financial Group Inc ABK.N called its transformer Ambac Credit Products LLC.
Business boomed after Wall Street firms forced insurers to count these transactions as derivative contracts, rather than insurance contracts. Swings in the value of the swaps sold to Wall Street helped banks offset fluctuations in the underlying bonds.
The swaps also let investment banks move commitments off their balance sheets. Banks meanwhile could book profits up front. They used a trading strategy known as the “negative basis trade,” the paper said, citing unnamed industry participants.
Reporting by Joseph A. Giannone; Editing by Gary Hill