A former federal regulator and law professor warned a panel of state insurance legislators this weekend that if they don't immediately act to regulate the market for credit default swaps they risk losing their powers to the federal government.

The swaps market has fallen into a regulatory "black hole" and state governments must step in to fill the void, University of Maryland law professor Michael Greenberger said. Even though he believes the states have done a good job regulating the insurance businesses they had control over, the conventional wisdom in Washington, D.C., is that the states have failed and a national insurance regulator is needed, Greenberger warned.

"The American public somewhere, somehow needs aggressive government standing up for them, and my view is that the states should move aggressively until they're told to stop," said Greenberger, a former director of the trading and markets at the Commodity Futures Trading Commission. He made the comments to state legislators from six different states at a public hearing held by a committee of the National Conference of Insurance Legislators.

In a credit default swap, the seller of a contract receives a premium for agreeing to guarantee payments of an underlying security, such as a corporate bond, if it defaults. Although they can be used as a type of insurance - even though they aren't regulated as such - only 20% of credit default swaps are purchased by someone that owns the underlying risks, the New York Insurance Department estimates.

The other 80% - so-called naked swaps - are sometimes purchased to hedge against another risk one company might have with another, such as outstanding receivables. But often, someone purchases a CDS solely to make a directional bet against the firm or structured finance product.

Greenberger said state governments should look to regulate both types of credit default swaps. Those that have insurable interests should be treated like insurance, with appropriate reserves or collateral in place. Those that don't should be voided as unlawful insurance, he said, the equivalent of purchasing a life insurance policy on another person.

The New York Insurance Department in September said it planned to regulate the 20% of the market that acted like insurance, but didn't the have authority to monitor the remainder. In November, though, it announced it was delaying its plans because the federal government appeared to be taking steps to regulate the market.

Insurance superintendent Eric Dinallo said at the hearing Saturday that the legislators should give the new administration a few months to create a regulatory to framework before acting. He said a central exchange with high margin requirements would essentially price the naked swaps out of the market, leaving only those looking for a form of insurance in. He cautioned against each state developing their own solutions.

"The correct solution is some kind of centralized exchange function," Dinallo said.

Assured Guaranty Corp. president Michael Schozer also spoke Saturday, telling the legislators that credit default swaps have many useful purposes, such as for bank loan syndication. The problem has not been the form of credit default swaps, but rather the risk the companies underwrote - structured finance products filled with U.S. housing market exposures - and triggers that required companies post collateral on ratings downgrades, causing liquidity problems at insurers.

Banks often both buy and sell credit default swaps, so they have collateral moving both in and out of their books. The insurers typically only sold credit default swaps, which forced them to sell illiquid assets at fire-sale prices to meet collateral postings triggered by rating downgrades, accelerating a downward spiral. The problems at American International Group's financial products unit did not occur because the products it had backed defaulted, but because of the collateral they were required to post, Schozer said.

He recommended stronger risk management requirements and statutory accounting rules that would ensure embedded risks hidden in leveraged instruments get taken into account. Schozer also suggested banning insurers from writing CDS contracts that require collateral postings based on downgrades.

Robert Pickel, president and chief executive officer of the International Swaps and Derivatives Association Inc., also defended the usefulness of credit default swaps. He also cited the successful clearing of CDS contracts that referenced now-bankrupt Lehman Brothers as evidence the market works as intended.

Greenberger, however, later suggested the settlement was only successful because the government had injected - through the Troubled Asset Relief Program and the Federal Reserve purchases of assets - hundreds of billions of dollars into the financial institutions involved in the transactions. He said if AIG had to pony up collateral or set aside reserves before hand, it would have prevented them from writing so many swaps.

"If you have widespread failures, there's a limit to how much the United States can keep giving institutions to make these payments," Greenberger said. "And the idea that these banks are dealers and they're like bookies and have an even book. No, no, no, no, no.

"Why did Bank of America need another capital infusion? Because Merrill Lynch thought that the way to make money here is to sell CDS. Why did they think that? Well they thought that housing pricing would always go up, so they were not insuring a real risk. They thought they had learned how to print money."

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