Eric Dinallo: "We modernised ourselves into this ice age"

To his credit, Eric Dinallo, the New York Superintendent of Insurance, did take the brewing mess at bond insurers MBIA (under his jurisdiction, and completely intransigent) and Ambac seriously enough to try to Do Something About It. In the end, his efforts came to nought, swept aside in the tidal wave of credit messes. But MBIA and Ambac were writing policies that in economic substance were very similar to the ones issued by AIG (regulated by the Office of Thrift Supervision). While AIG had stopped writing the toxic contracts by then, earlier action might have led to a less catastrophic unwind (look, it’s hard to imagine any outcome worse than the unsupervised decay now in motion).

As a New Yorker who has prevailed upon the insurance division, I must say I have found it to be exceptionally well run, more professional than the vast majority of private businesses I deal with. I don’t know whether Dinallo can take credit for it, but he certainly did not mess it up.

Dinallo has penned a colorful and informative piece for the Financial Times describing why having an unregulated market that makes side bets on securities prices isn’t such a hot idea. And he points to some legal avenues that could have been used to rein in credit default swaps that were blocked that were new to me.

From the Financial Times:

Many compare this financial crisis to the stock market crash of 1929, but it is closer to the credit freeze and bank panic of 1907….

The bank panic of 1907 is remembered for J.P. Morgan forcing all the bankers to stay in a room until they agreed to contribute to fixing the crisis. What has been forgotten is one major cause of the crisis – unregulated speculation on the prices of securities by people who did not own them. These betting parlours, or fake exchanges, were called bucket shops because the bets were literally placed in buckets.

The states responded in 1908 by passing anti-bucket shop and gambling laws, outlawing the activity that helped to ruin that economy.

What has that got to do with today’s crisis? Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration….AIG Financial Products, the unit that sold almost $500bn (€379bn, £353bn) of them, may therefore be viewed as the biggest bucket shop in history.

Credit default swaps started out as essentially an insurance policy. If you owned a bond in a company and were concerned it might default, you bought the swap to protect yourself….Banks bought them to reduce the amount of capital they were required to hold against investments – in other words, to avoid regulation. Because they owned the swap, banks claimed they no longer had the risk of a default of the bond. Others bought swaps without owning the bond to place a bet on a company’s future.

But there was serious concern that swaps violated the old bucket shop laws. Thus, the Commodity Futures Modernisation Act of 2000 exempted credit default swaps from these laws. The act also exempted them from regulation by the Commodities and Futures Trading Commission and the Securities and Exchange Commission. Unregulated, the market grew enormously.

Thus, one of the major causes of the financial crisis was not how lax our regulation, or how hard we enforced, but what we chose not to regulate.

Indeed, what we decided was old fashioned and in need of modernisation was, in fact, an effective check on an activity that for 100 years had been illegal, for good reason. As a result, we modernised ourselves into this ice age.

The fear in 2000 was that if we regulated credit default swaps and required holding sufficient capital, the market would go where unregulated sellers could make more money. We forgot that the biggest competitive advantage of the US financial system has always been safety, security and transparency. If we destroy that perception, the long-term cost to our society is incalculable.

Yves here. That view may sound antique to those brought up on the “regulations drive activity elsewhere” mantra, but in fact, until perhaps 10 years ago, when the new ideology became entrenched, one would regularly read that the success of the US capital markets was due to its perceived safety, which in turn was due to its high standards of disclosure and investor protection. In other words, regulation. Back to the article:

What did we learn at the start of the last century that we then disregarded either through amnesia or hubris? What lessons, now learnt twice, can be gained from all this?

There are basically four ways people hand over money to financial institutions: 1. Bank deposit accounts. You deposit your money and the return of principal and interest is guaranteed. Banks are required to hold enough capital to deliver on that promise. 2. Insurance. If you suffer a loss, you are guaranteed recovery. Insurance companies are required to hold capital to meet that guarantee. 3. Gambling. If your bet wins, you are guaranteed your winnings. Casinos and racetracks are required to hold enough funds to ensure payouts. 4. Investment. There are no guarantees when you invest in a stock or a bond. You could lose everything. Appropriately, investment bank capital requirements are much lower. The first three categories contain guaranteed payments against future events; the fourth is merely aspirational.

We thought we could use alchemy to create a perfect fifth category that allowed guarantees supported by little or no capital, and that would produce hefty profits with no real risk. Instead, we re-created the old bucket shop gambling parlours on steroids and another credit crisis. Financial products should be seen as belonging in one or another of those four categories and regulated appropriately. If there is a guaranteed outcome, then the guarantor must hold sufficient capital to make good on that guarantee. A key lesson of this crisis is the danger of insufficient capital and the risks of alchemy.

Credit default swaps must be regulated and sellers must be required to hold sufficient capital. That will make them more expensive, but it will mean the guarantee has real value.

Does requiring adequate capital mean the end of financial innovation? Of course not, it just means that most institutions will operate with less leverage. Risk and reward are integral to capitalism. But innovators should risk their own capital, not the entire financial fabric. Setting that balance is where effective regulation comes in.

In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver. If you offer investments, be transparent, but buyer beware. No one should ever again get to bet the store called the Entire American Economy. And certainly do not assume we are smarter than folks 100 years ago. As Mark Twain is supposed to have said, history may not always repeat itself, but it sure rhymes.

Print Friendly, PDF & Email


  1. Anonymous

    good luck with your book

    work hard

    the shame is concentrating on your book, you will not have enough time to focus on your blog which helped you gain fame to get the book contract

    i will follow the guest bloggers, i hope that keep the traffic up till you can return to your blog with more time

  2. Swedish Lex

    “No one should ever again get to bet the store called the Entire American Economy. And certainly do not assume we are smarter than folks 100 years ago.”

    The criticism in the article obviously applies to Europe too. For the last couple of decades, the EU has brought down barriers, freeing up the EU capital markets and replacing old national rules with new, federal, EU rules. The latter have often been more free market that their national predecessors.

    Not everybody agreed. Turns out that, for instance, the socialists in the European Parliament had many valid points that often were ignored. They were regarded as leftist then but some of what they said then seems more like common sense now, like Dinallo’s comments. And I guess that Dinallo is not a European social democrat.

    The pendulum is now swinging back in the other direction. It is too early to predict how far this will go, but I suspect that the we during the coming 2-4 years will see a continued major overhaul of financial regulation. G 20 is only the hors d’oeuvre.

    Until now, the EU has looked at the U.S., and at the UK, and often (but far from always) used them as models. Going forward, the opposite will obviously apply, although there is no existing system to mimic. Hence room for new approaches and hence why France is lobbying hard to get the crucial position as EU Internal Market Commissioner for the coming five years…..(the two past such Commissioners have been free market oriented, which now is used as argument for change).

  3. Anonymous

    by Simon Johnson

    What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances.

    Simon Johnson, a professor at MIT’s Sloan School of Management, was the chief economist at the International Monetary Fund during 2007 and 2008.

  4. Anonymous

    Didn’t Eric Dinallo try to lend US$20B from AIG’s New York subsidiary to its parent right before the AIG implosion in September?
    I can’t reconcile that action with prudent regulation.

  5. MarketBlogic

    Yves, I think you’re missing the most important problem with CDS’s versus tradition insurance: traditional insurance requires capital pools to ensure payment of claims that are in large part based on premiums paid and highly segregated into distinct pots (often at the state level); CDS’s really are just insurance contracts BUT have no such mechanism other than the general creditworthiness of the selling entity. Worse yet, instead of segregating risk off to the side into separate pools as real insurance does, the CDS market seems to trade risk back-and-forth among the same parties. Just absolute madness, IMHO.

  6. winter`mute

    Message to Barack Obama:

    FIRE Geithner and HIRE Dinallo

    Then you will have a chance of fixing the credit crisis without a depression.

  7. max

    Well, I’m pleased. That’s what I’ve been thinking and calling the CDS market, and it’s nice to have someone agree with me. The giveaway clue is that the bets are clonable: if some company issues a million dollar bond, and 10,000 insure for (any value) for a year, how much is the payout? 10,000,000,000! Since you can’t predict defaults the way you can predict life expectancy, and this would be a risk pool based on one life anyways, you either need a true offsetting bet so it nullsums, or you have to hold 10,000,000,000$/reasonable equivalent. If you were going to do that without charging 10b, you’d need … collateral in the bond-issuer. Might as well just buy a bond or the stock.

    [‘We moved the risk to um, ourselves and multiplied it! Yay! Innovative!’]

  8. Anonymous

    The article highlites the insidious capture of the world economy by the radical libertarian republicans and the financiers who took advantage of the vacuum. Perhaps the problem is so pernicious because we cannot, even now, rationalize the coup on the US government that has transpired. I laugh when I see Cheney making claims that the US is “more secure” because of his policies. The man is batshit crazy yet still gets full play in the so called MSM.

    The heroic banking rescue operation is like watching the finale of a great battle in slow motion. I cannot see the rational reason for AIG, Citi, BofA, etc. to be still standing in their current form, untouched by swift restructuring and bankruptcy. I cannot understand why the financial weapons of mass destruction have not been defused. I cannot understand why there have been no prosecution of the boilershop mortgage and securities operators, rating agencies, and insurers when fraud is so obvious.

    Perhaps the conspiracy theorists are right: There is no rational reason other than the capture of the US government by financial terrorists.

  9. Anonymous

    He is wrong about 1907; it has very lttle to with the current crisis. One huge difference was that vast majority of banks and trusts were solvent— which is to say the bank runs were largely irrational..

    He is also wrong about the short sellers. The 1907 short sellers detected an artificially inflated stock price (United Copper). They were sending accurate price information to the market and exposing market manipulation.

    The 1907 short sellers were the good guys.

  10. Anonymous

    We forgot that the biggest competitive advantage of the US financial system has always been safety, security and transparency.

    Well, those three, plus sheer size.

  11. Stuart

    Trillions in customized OTC performance contracts have been triggered with no sufficient capital behind them. What to do other than Presidential order declaring null and void these contracts – can we live with the unintended consequences of that move too. Overlay this with the fact that US government finances are built upon a ponzi scheme model…. no way out other than complete system re-boot.

  12. Anonymous

    Excellent post. Isn’t it worth noting, though, that the unregulated and unreserved CDSs were allowed as capital assurance by both US and European bank regulators? That wasn’t a natural conclusion after the CFMA of 2000 was passed. On the contrary.

  13. MutantCapitalism

    You'd think that the monoliners and protection sellers would at least investigate what they're selling protection on AND parties involved. Pooling & Servicing Agreements (PSAs) detail which mortgage servicer will process mortgage payments for the REIT and terms under which they will do so.
    Mortgage servicing fraud has been rampant since late 1980's but has in recent years reached epidemic proportion. if you want to know more about it.
    I-Bank subsidiary servicers and many contract servicers are known to have appalling track records and this information is readily available in case law, FTC settlements and even 10K filings. One would think, knowing they were not required to maintain reserves, they would have been even more cautious about who and what they got themselves involved with. Didn't anyone at AMBAC, MBIA, AIG get that the 'protection buyers' were more often than not, the very same ones controlling the servicers and directing them to manufacture bogus defaults so they could collect many times over on these rigged bets? Insider trading has never before reached such heights.

  14. texasradio

    Bucket shops? I fail to see how bucket shops had the slightest thing to do with it. As I understand it, bucket shops did not buy and sell actual securities. As such, how could they have influenced the market?

    The more likely reason for the anti-bucket shop legislation was that the bucketeers were costing the NYSE potential business.

  15. Timo

    “Perhaps the conspiracy theorists are right: There is no rational reason other than the capture of the US government by financial terrorists.”

    How many US Congress members have net worth below a couple million dollars? I’d bet NONE.

    So how many Representatives from middle class (=majority) are in Congress? I’d bet again NONE.

    Americans have de facto plutocracy and in plutocracy Representatives take care only of the rich elite, nobody else. There is no republic left anymore.

  16. sanjay

    Dinnello is onto something but he has missed the biggest scam ( I haven’t seen it commented on else where)

    The scam was the double and triple counting of the same capital. Simple example- a lot of banks were able to count insurance policies from AAA insurance companies as part of their Tier 2 capital. However, the insurance company was not required to subtract the capital value to bank from their own capital. Similarly banks owned preferred shares in Fannie and Freddie but were not required to deduct the value of the preferred from their capital. They in turn could issue preferred owned by other banks. Essentially one dollar of capital was counted twice or thrice. The regulatory reform needs to have a simple principle- if what you give counts as a capital for me then it must result in less capital for you.

  17. Anonymous

    Larry Summers: CDO Salesmen for DE Shaw


    Larry Summers is rumored to have been selling mortgage-backed securities for DE Shaw to sovereign wealth funds and foreign banks, including after credit hedge funds started failing.

    “According to sources who attended meetings with him, Summers traveled to Asia during July 2007 with a pitchbook recommending the AAA-rated tranches of collateralized debt obligations to Asian sovereign funds and financial institutions, in his capacity as a Managing Director of the hedge fund D.E. Shaw.”

  18. Anonymous


    The point is that the side bets on the securitized instruments were done by traders who did not own the over leveraged collateral.

    They were bucket shops with computers.

  19. realty-based lawyer


    Dinallo, like Greenspan, understandably omits the role played by the NYS Insurance Dept’s failure to regulate AIG’s CDS. Yes, there were gambling-contract questions. But the larger question was whether CDS were contracts of insurance (as Dinallo said last fall that they were, at least to the extent the protection buyer held the underlying bond and so had an insurable interest in it). I believe they are properly viewed as contracts of insurance. If so, AIG’s guaranty of AIG FP’s CDS was insurance (I think, but can’t clearly remember, that the CDS were in fact guaranteed by one of the insurance companies rather than the holding company). Those guaranties were regulated by – guess who – the NYS Insurance Dep’t. Or should have been.

    That’s a major failure. If those guaranties were insurance, they were financial guaranty insurance, better known as bond insurance – the sort of insurance done by monolines like Ambac, MBIA, FSA et al. No AIG company was licensed as a financial guaranty insurer. Therefore, under Dinallo’s own theory (which, again, I believe is correct), AIG shouldn’t have been allowed to get into the CDS business at all.

    Separate point: Dinallo also omits the fact that the NYSID rewrote the Insurance Law in 2005 to specifically permit financial guaranty insurers to write CDS.

    Bona fides: I’m a lawyer and a former specialist in financial guaranty insurance. For confirmation of my conclusion, check the definition of financial guaranty insurance in S. 6901(a) of the NY Insurance Law. And read Article 69’s CDS provisions.

  20. kfunck1

    Can anyone tell me how the hell MBIA and AMBAC are still around? They’ve been on deathwatch since B.S.

  21. Anonymous

    Since the US markets are the working model even if you now revert to regulating derivatives including protection on your bets here at home, you’ll chase bettors to other worldwide markets that refuse to follow the new guidelines and the undersight will continue. Why? Because the commission on sales are a money maker since no one ever funds the policies.

    If rating agencies would just do their job they alone would expose the true risk involved in taking a position against yourself along with all the other outside bettors.

    So, regulation or re-regulation would have to happen on a blanket scale to be effective.

    Same goes for re-establishment of the up-tick rule.

  22. Anonymous

    “you’ll chase bettors to other worldwide markets that refuse to follow the new guidelines and the undersight will continue.”


    Regulatory capital requirements are the cornerstone of any stable market. To achieve reasonable stability there must be some assurance that most of the financial institutions are able to meet their obligations and thus survive the inevitable periods when markets go against them.

    Even if an institution does blow up, reg cap requirements keep them from achieving massively negative net values. At least there is something left to divide up to creditors.

    The scary thing right now is that some of these large institutions are not merely a bit short of capital; they are undercapitalized for notional exposure by orders of magnitude.

    Anyone who wants a case study of this should review the fall of Long-Term Capital Management. LTCM was a mega hedge fund with massive exposures. Their trades were actually good for the most part, but they had only about 4-5 billion in capital for 100+ trillion in notional exposure. The markets went against them for a bit, and they collapsed. They were bailed out by a group of bankers organized by the Fed. Ultimately, the bailout bankers came out whole since, unlike the situation today, the trades that were made were basically sound.

    — Crowman

  23. Anonymous

    What did we learn at the start of the last century that we then disregarded either through amnesia or hubris?

    We forget that 10 years ago the “threat” than no US banks would be in the top 10 in the world. It wasn’t hubris so much as penis envy.

    European and Asian banks were growing large quickly – through increased leverage. US politicians wanted increased leverage just as much as the US banks did.

  24. Anonymous

    For heaven’s sake – AIG lost about as much in boring old securities lending by its boring, highly regulated insurance subs as it did with credit derivatives.

    Maybe Dinallo can write about how he completely missed that, right under his nose.

    Of course, if I were a regulator I guess I would rather write about all the great things I would have done if only my powers were even greater, rather than mull on my own glaring failings.

    This link notes the $44 billion in loans to the securities lending activity at year end.

    Credit derivatives took about $54 billion; the rest of AIG FP took another $26 billion, IIRC.

    Tom Maguire

  25. Anonymous


    The monolines were smarter than AIG. Their CDS contracts state explicitly that they only have to make payment when the defaults are realized. Thus they will only ever have to make a principle payment on a bond when the bond fails to pay at maturity — there are no collateral calls and no one-time payments on event of default.

    In the meanwhile on mortgage debt they probably have a decade or so to process claims of fraud against protection buyers in the courts.

  26. kfunck1

    My interpretation was that they were still losing money hand over fist, and that they were going to have a near impossible time getting new business as a result of ratings downgrades.

  27. Yves Smith

    realty-based lawyer, Tom Maguire,

    The CDS were written by the holding company, and were not guaranteed by any of the subs. The holding company was regulated by the Office of Thrift Supervision.


    Dinallo can regulate only insurance co’s domiciled in New York State. That’s why he could try to do something about MBIA (a NYS domiciled insurer) and not Ambac (Wisconsin).

    AIG is an international company. Many of its insurance subs are in foreign countries. AIG has made a science of regulatory arbitrage. I have no doubt they’ve located subs to the extent possible in jurisdictions with permissive regs.

  28. Anonymous


    I don’t believe that the monolines are healthy — they’re just a lot healthier than other major sellers of CDS.

  29. Anonymous

    “Does requiring adequate capital mean the end of financial innovation? Of course not, it just means that most institutions will operate with less leverage. Risk and reward are integral to capitalism. But innovators should risk their own capital, not the entire financial fabric. Setting that balance is where effective regulation comes in.”

    Huh? Capitalism? Do you mean capitalism as in ‘free markets’ and ‘private property’?

    The scam view that “regulations drive activity elsewhere” is just as false as the view that capitalism, ‘free markets’ and ‘private property’ even exist. Its doublespeak bullshit.

    The fifth way that people hand over money to financial institutions is through the deception used when the wealthy ruling elite purchase the politicians to craft the legislation that favors them exclusively. We are suffering aggregate generational corruption of the scam ‘rule of law’ in all areas of society. And it is now intentionally on roids for a whole range of reasons that need to be explored.
    Its scamerica — get over it — the old vanilla ‘safety, security and transparency’ are gone. Democracy is a sham myth!
    We are experiencing across the board hyped up intentional corruption that is consolidating power globally and decimating the middle classes. When you use their gangster doublespeak you assist in their deflections.
    We are wallowing in the individual hypocrisies and deceptions.
    It is time to connect the dots …

    Deception is the strongest political force on the planet.

    i on the ball patriot

  30. realty-based lawyer


    The press doesn’t focus at all on CDS structure. Unfortunately, the structure’s important here.

    AIG’s CDS were run out of AIG FP, which probably means it set up SPV subsidiaries in tax havens (possibly technically owned by charitable organization) to write the swaps (as in sign the documentation). Those SPVs were probably very lightly capitalized; to get the appropriate rating — AAA, if I remember correctly — the CDS would’ve had to be guaranteed by an AIG entity that was rated AAA. Don’t think that was the holding company, which IIRC was a AA rather than a AAA entity (I could be wrong); if so, it was probably one of the AAA insurers.

    It doesn’t really matter, though, whether the CDS were guaranteed by an insurer or the holding company. First, AIG has ten insurers licensed in New York and therefore regulated by the NYSID (which regulates any insurer doing business in NY wherever it’s domiciled). Second, the holding company clearly does business in NY; if it was illegally guaranteeing CDS, the NYSID had and has plenty of authority to stop them. Instead, the NYSID knew all about CDS activity, which it had explicitly permitted for several years and, as I mentioned, legislatively endorsed in 2005. Like many other regulators, the NYSID thought CDS were good things.

    And the question whether CDS were insurance was also well known to the NYSID as well as within the industry; it was basically camouflaged through some rather simple structuring techniques that the regulators failed to question during triennial examinations. Dinallo’s article is rather brazen chutzpah.

  31. Yves Smith

    Realty-based lawyer,

    AIG was rated AAA at the parent . In fact, Dinallo gave some of the subs permission to upstream cash to the parent to try to shore it up. That course of action would have made no sense if the guarantee sat elseswhere:

    Forgive me, but my understanding is regulators seldom cross jurisdictions. Ambac also does business in New York, but Dinallo did not try to assert his supposed authority there, he turned to the Wisconsin regulator.

    Even if Dinallo had been inclined to block the CDS operation, he was not its primary regulator. The normal protocol for reining in a miscreant is chats and or missives telling the miscreant operation to cut it out, and that usually suffices, because worst come to worse, they can yank its license, which effectively puts it out of business.

    Conversely, if a regulator who does not have primary authority tries to assert oversight, unless it is over a very narrow issue over which the second regulator can legitimately claim primacy, the regulator under which the entity is licensed will go ballistic. The OTS is under Treasury, and the Bush crowd would have come down on him like a ton of bricks. Believe me, Dinallo would have lost that fight. His jurisdictional claims were not strong, and the politics were completely stacked against him.

  32. Anonymous

    Insurance regulators generally don’t cross jurisdictions, but New York’s ID is something of an exception. So much so that it’s common for large holding companies to have one insurance subsidiary licensed in 49 states and another subsidiary licensed only in New York.

  33. realty-based lawyer


    I’ve now glanced through AIG’s 10-K. It appears that the holding company guaranteed all obligations of AIG FP, and it seems probable (though not clear) that AIG FP wrote its CDS directly rather than through SPV subsidiaries. If so, Dinallo could simply have told AIG that its NY operations couldn’t engage in the business of guaranteeing CD without a NY financial guaranty license. If AIG had refused to stop (very unlikely), he could have revoked their license and forced them to sue him in NY courts. He’d have been entirely within his regulatory jurisdiction; no one would’ve challenged him. Not even the OTS, since insurance is regulated by the states without pre-emption by the Federal government.

    Also, as Anon of 7:31 said, the NYS ID (like California and even Wisconsin) applies its rule extraterritorially: if an insurer has a NY license, it has to follow NY rules for its entire business, wherever conducted.

    You’re right about the normal protocol. But normally, as you said, the insurer does what the regulator wants after those chats and missives, for fear its license will be revoked. The NYSID never, as far as I know, held those chats or sent those missives, either before or during Dinallo’s tenure. Instead, they went along with other regulators in approving CDS when they could have shut them down or at least brought them under regulation.

    And Dinallo somehow didn’t have a word to say about that.

  34. Anonymous

    why did the guys in the bucket shops put their bets in ‘buckets’ ?

    were all these guys in a pit, and a pail was lowered down by a string and they would put buy and sell orders in the bucket, after which it gets lifted back out of the pit?

    thats the only explanation I could come up with.


  35. Anonymous

    So many explanations, but never the names of the managers of America Inc. who are responsible for this malfeasance. Sure, we know a few (Gramm and wife, Rubin, Greenspan, Schumer, Lieberman, etc.). But why can’t just one non-profit or media outlet list all those who participated (Senators and Reps) and detail the “financial contributions” (i.e., bribes) that led them to sell the government? Managements are motivated by greed. It’s the responsibility of government to prevent that greed from causing public harm. I say send all those responsible for our enormous new financial burdens to hell.

Comments are closed.