Here’s a stupid regulatory idea: regulate credit default swaps (CDS) as “insurance” if the purchaser owns the underlying security. This is the “brainchild” of NY Governor David Paterson.

The first obvious problem is that, as a tradable instrument, CDS are categorically different from, oh, I don’t know, a financial guaranty (FG) policy. Not to mention that the target market for CDS protection usually handles their securities a little differently than the target market for financial guaranty policies does. Buyers of CDS are more likely to do weird things with their securities, whereas buyers of FG are more likely to just let them sit there exuding yield until they mature. But I digress.

The next obvious problem is that, gee, I wasn’t aware that the State of NY ever did a good freaking job of making sure the financial guaranty insurers domiciled there were financially strong, so what makes them think they’ve suddenly opened up a big can of “competence” and are ready to handle the CDS market? Ambac and MBIA ring any bells? Oh, maybe it was the CDS business that got these fine insurance companies into trouble, and the FG business was A-OK because the State of NY was watching it! If only the State of NY had been on the case where those CDS were concerned, it would’ve been different! Or maybe it was the competition from unlicensed, unregulated, and irresponsible market participants that did ABK and MBIA in! Yeah, that’s it.

You know, it’s not like any insurer ever went belly-up from having insufficient reserves because of a LACK of state regulators and requirements about reserves! Fact is, “adverse loss development” kills more insurance companies than hurricanes, and the regulators don’t – can’t! – prevent it, despite hosts of requirements and all the regulatory power they have over insurance. But it’ll be different with CDS, of course.

It occurs to me that the idea is not only impractical but unenforceable, to boot. I buy a CDS where I want, from whom I want – hint, not a licensed insurance company – and five milliseconds later buy the debt. It wasn’t an “insurance product” when I bought it, as I had no insurable interest at the time of purchase. So now we’re on a slippery slope where we keep adding rules to the game and the players will always be one step ahead of the dungeon masters.

Paterson has an answer there: ask the FedGov to step in and regulate those CDS exchanged without insurable interests behind them. Bright idea, fella, bright idea. The Fed’s have done an excellent job so far with financial regulation.

I wouldn’t be surprised if ABK and MBIA were supporting Paterson in this brave move, however! It’s the nature of the beast. Submit to a little regulation if it limits future competition from entering the market, and provides a little leniency for past sins? Perhaps a donation or several to Paterson’s campaign might have been made by these companies? I’ve looked, but didn’t find specifics at that level. However, David Paterson does strike me as the kind of guy that might be listening closely to his donors, especially those that give big constituents. Therein, I believe, is the heart of the proposal.