Q&A: NY Insurance Chief Eric Dinallo
As he winds up his first year on the job, New York State Insurance Superintendent Eric Dinallo chats with IDD.
By Yael Bizouati April 7, 2008
It's been a hectic and unexpected first year for Eric Dinallo as New York State Insurance Superintendent. Appointed by former New York Governor Eliot Spitzer in April 2007, the 44-year-old Dinallo has had to face critical situations in the financial markets fairly quickly. His effort to rescue and bail out the monolines, his proposal to split their municipal business from their structured finance business, and reaching out to Berkshire Hathaway put him at the center of the credit crisis.
More recently, he also dealt with the resignation of Spitzer, with whom he worked from 1999 to 2003 as the Attorney General's chief of the Investment Protection Bureau.
Last week, Dinallo sat down with IDD to talk about the Ambac negotiations, how he approached Berkshire, his thoughts on the credit crisis, and what he hopes to achieve in the future.
Eric Dinallo
IDD: What do you think about the whole credit crisis and who do you think is to blame?
Dinallo: I can't point any fingers on this, I don't fully grasp who is at fault for all this, but I know how it started. When a banker at a community bank had a certain amount of capital to lend, they lent it out to a community and sat across from the borrower and they made underwriting decisions. They were very hopeful they would be paid back on their loans, just like the movie "It's A Wonderful Life." Reputation mattered, history mattered, they did great things in their community with capital and they built a book. Then a smart investment banker said, "If we securitize, you'll have more capital to loan and do more things in the community and you won't have to hold on to all this risk." It was a smart idea. I'm sure that first book of business performed brilliantly because the loan decisions were made as if that banker would have to hold all that risk and moral hazard would not creep in. But by the fifth round of securitization, the bankers think, "I don't own this anymore." So the incentives and the decision metrics changed. Wall Street is essentially holding a book that looks nothing like the first one. I don't know who's at fault and where you draw the line, but after a while, there can't be that many people in the community that qualify for a loan.
IDD: Any thoughts on the recent proposal from the Treasury Department?
Dinallo: It was very thoughtful, but there are some real substantive issues. I am not an absolute opponent to any federal involvement in insurance. I think there are areas like reinsurance and other capital market-intensive areas where it's a reasonable discussion to see what, if any, role the federal government should play. I am, however, very worried about the optional part of the optional federal charter. Basically, what they're saying is that a company can decide whether they want to be state or federally regulated in the insurance industry, it's an option. That's why it's called an optional federal charter. My view is that allowing regulated entities to choose their regulator has the tendency to lead to regulatory arbitrage and a race to bottom. You have to be married to one person. If you are really discussing prudential, principles-based regulation, which they say is what they're going towards, that involves a fairly serious, committed dialogue in the relationship. You basically end up living with each other and understanding each other's motives, desires, the company's business plan, what the regulator's expectations are, what they're doing to manage risk, what we expect on how to protect our consumers, what we expect on solvency. If you have the option to switch out of that relationship, I don't believe that a robust exchange can occur because companies and regulators need to be kept together for that relationship, or they need to not fear the relationship. Too often we've been very enforcement-minded and not enough of a prudential, holistic regulator. The history of state insurance regulation is a very good history. The industry and the regulators ought to be proud that in 150 years, we have done a good job at avoiding major insolvency or sector blow ups. It's a good history with a strong legacy of consumer protection.
IDD: Do you think the reputation of the insurance industry is tainted now given what's happened?
Dinallo: I think the insurance industry and the regulators have the right to say, "Hey, there have been problems in the financial services industry, but in the insurance industry we're not as involved in a lot of these issues." Part of the reason is because of this intimacy. We really live with these insurance companies. We have people on site, examiners -- to be fair, much like the Fed lives with some of the commercial banks such as JPMorgan Chase. I really believe you can't overemphasize how much insurance is a consumer-oriented enterprise. I think the federal government does markets better than a state-by-state undertaking, but I'm surprised at the concept of them starting to regulate -- which they say in the report -- auto insurance, homeowners insurance. We get 70,000 consumer complaints a year here in New York alone. There are 13,000 insurance regulators across the country, so the federal government would need an agency of about 10,000 just to be able to handle the optional part of this. What we (states) do not do as well is that we don't register products well, we don't go to market quickly enough. You need to go to every state to get your new product registered, that's a little bit of a problem.
IDD: Is that what is happening with Berkshire's new financial guarantor unit?
Dinallo: Yes, but there we got our act together. We've done 41 states in record time. That's unusual. One question is, is there a faster way to do it? One idea is "passporting," where you have one state be the passport for all the other states. There is also the Interstate Compact, which allows states to develop uniform national product standards for life insurance, annuities, disability income and long-term care insurance products, and provides a central place for filing for those products.
IDD: In regards to Berkshire's licensing, could you explain some of the concessions you made and how you worked to expedite the process?
Dinallo: Berkshire had a lot of capitalization, but because they weren't rated yet we let them borrow the rating of the parent and utilized the backing of their reinsurance entity, National Indemnity. I spoke to the staff and said I need this license faster than you ever licensed any other company. I didn't know what "fast" was so I said to them, "Can you do it in a week?" and they thought I was joking. They did it in six weeks which was by far the fastest we ever did it. I'm incredibly proud of the department's actions.
IDD: Could you tell me how you approached Ajit Jain (president of Berkshire's reinsurance unit)?
Dinallo: I had spoken to Ajit Jain and Brian Snover about markets like medical malpractice and workers' comp that I was hoping they would put capital towards, and I had been impressed with the way they think about issues. So when I saw that we would likely see some of the bond insurers losing their AAA ratings, I had a fear, which was instinctual, but now turns out to be correct, that some of the municipalities would need to have their bonds rewrapped. That takes capacity and a certain amount of capital, and you have to be licensed to do it, so I called Ajit mid-November and I left a message. He didn't call me back for a day or two. He claims that he thought I was calling him because he thought I had a customer complaint for something with GEICO, for instance. When he heard I was calling to say, "I really need you in the business and I'm willing to license you as fast as possible, but I need it quickly because I feel there will be some New York domestics on the edge here," he was very excited that a regulator called him with a business proposal. For him there was an interesting tension, because for these purposes, they've otherwise been licensed in Nebraska or Connecticut and I think he understood that to me it was important that he did it in New York for a lot of obvious reasons. So he went to Warren Buffett to explain why New York and the results were very good, they were able to start to rewrap New York muni bonds very quickly and they were also able to offer capacity very quickly. That is important if we ever need to do some risk transfer off the books of ACA Capital or FGIC, for example, as they get downgraded.
IDD: Can you talk more about FGIC?
Dinallo: Well, we're in close communication with the company. They need to demonstrate a very serious capital-raising plan or there are only going to be very limited choices. If they can't raise necessary capital and they go to a junk status, then we have to decide how they proceed, including whether they end up in rehabilitation -- which is in a sense the equivalent of bankruptcy. Then you have to decide whether you start to segregate capital based on what kind of risks they wrote. I hope we don't have to go there because it's an extreme position. They could volunteer for it or apply for restructuring if they wanted to. We had examiners on site last week and we've asked them for a very detailed plan over the next four weeks.
IDD: When do you expect an outcome?
Dinallo: By the end of the month there has to be some kind of outcome on FGIC. That could mean a capital injection, that could mean they are bought, that could mean rehabilitation...
IDD: When you say "capital injection," is this an Ambac-like situation?
Dinallo: Yes, but the problem is that they are closely held so I don't know what it means exactly for them. The people who could naturally inject capital for them would be their current owners: PMI, Cypress, Blackstone.
IDD: Did you contact other people besides Mr. Jain at Berkshire?
Dinallo: There were not a lot of AAA-rated companies out there, so it wasn't clear who else to call. It turns out that subsequent to that, we've had some interest from some bulge-bracket banks and private equity firms, and under our system they could capitalize a subsidiary to AAA level and be in the business.
IDD: How do you explain that some monolines like FSA don't have any problems?
Dinallo: They were more restrained and conservative in the writing of their structured business, and they clearly did not overwrite during a time period where CDOs were very shaky. You have to understand the irony is that from the insurance companies' point of view, insuring the CDOs was technically less risky than insuring munis because many CDOs came AAA-rated. Muni ratings were uplifted and many had no ratings of their own.
IDD: What do you think of the role of the rating agencies?
Dinallo: They had a very short experience on CDOs and the statistical models they had showed them that defaults should be extremely unlikely. What they didn't account for is that people started making very poor due diligence decisions on mortgage loans they were extending. And also stuff began to correlate in a way they never imagined. They thought there was a geographic disparity that would save them from correlation but because everybody was harvesting these loans for the same reasons they became very correlated. Now, I think there is nothing inherently wrong with CDOs and CDSs. They're a great invention of modern finance and risk transfer. But unlike the muni side where there's decades of experience on what would cause defaults, there was no experience on the CDO side, plus there was correlation they never appreciated. Nobody ever asked the basic question: What would happen if there was a housing bubble or if this housing market is actually artificial because of the subprime and predatory lending?
IDD: Another interesting aspect with the agencies is that, while you're saying they had no experience, on the other hand they hold a lot of power, particularly in the Ambac discussions.
Dinallo: They affected a potential $3 billion transaction. I was very much part of the discussion with the company. I was part of the discussions with the rating agencies up to a point, but when it came to the decisions about the capitalization I was not and should not have been part of it.
IDD: How do you explain the discrepancy between their lack of knowledge and the fact they have so much power?
Dinallo: I am not a critic of the rating agencies. It's a hard job and if anyone thinks they can do a better job, step up. It's not like Wall Street got it right and all the agencies got it wrong. One company is gone, which probably wouldn't have happened if Bear Stearns were so much smarter than the rating agencies. I think it is a very hard thing to do. Markets and particular products change quickly and I don't think anyone really appreciated the amount of leverage that was applied here. One guy defaults on his mortgage and it has an impact on the whole tranche -- nobody really understood that. So I don't really blame them. I think models have to become simpler, the SEC should encourage, if not dictate, to the rating agencies that they get simpler and more consistent models. Sometimes when you're dealing with three, four, different agencies it's like dealing with foreign countries. They're not in synch with their modeling. You don't expect them to be all the same because then there would be no point to having multiple rating agencies, but you do exepct some commonality. No one minds being graded, but they want to be graded on a fair common scale
IDD: You've been on the job almost a year and your position has become high-profile. Can you explain what you do on a daily basis?
Dinallo: Pray [smiling]! I spend a lot of time in meetings where we get briefed on what issues are coming in the system. Each bureau produces a tremendous amount of outcomes on examinations of companies, consumer complaints, and they generate different possible policy decisions. I spend a lot of time speaking to consumer groups and executives of companies to learn what the current issues are in insurance. Most of what we've done has been generated by those meetings. On the bond insurance issue for example, things came to a head when I received calls from two CEOs pretty deep in that and a couple of government agencies that said "you need to step in because something's going to happen quickly." At that point, they had a network of intelligence on the rating agencies that was useful because they sensed there were going to be some downgrades. We knew companies were going to be downgraded and that it would cause a real concern with a potential domino effect and crisis. I also speak to the press a bit; it is important to communicate what we do for a living. The public should know what its public servants do, where their tax dollars are going. It is an important function if you want to move the industry and protect consumers -- telling people what you are planning to do is part of the job. I also spend a lot of time thinking. I try to set aside some time each day to see what percolates because I'm here every day with 1,400 people and I get a lot of ideas and input and you want to see which ones ring true. The World Trade Center insurance settlement and bond insurance actions rang true. I don't like to have a very methodical, scripted plan because I think you get tied to it and you can't react to the issues we've been reacting to in the past year. We've been pragmatic on a lot of the issues.
IDD: There were rumors that because of Mr. Spitzer's resignation, your tenure might be affected.
Dinallo: It doesn't look that way. I want to stay, I think there is a lot of work to be done. All of what we did this first year had good outcomes for any administration. I think very highly of David Paterson; he's a smart guy with proven leadership skills. He is a great public servant. I would like to think last year was good and I hope to have an equally good second year. There is something about me based on my history with the former governor that ties us together in people's minds, but I would have done any of the stuff we did last year with any governor. These were things I believed in, things that were right for both the people of the state and the industry.
IDD: Are other companies going to launch monolines?
Dinallo: We would expedite once they applied for a license. There is interest. The difference with Berkshire is that they had the underwriting capacity and had people in place to immediately go into the business. They had been thinking about it for a while. I didn't realize this but they thought margins were not high enough before because they believed there could be defaults in the muni world. Their view is that it's like picking up nickels in front of a steamroller. They're easy to pick up, it's easy money, it's safe, but if you make one bad underwriting decision it's a catastrophe, you're dead. They're right about that. Although people can say New York, California and Florida are not going to default on their general obligations, there are tens of thousands of small municipalities, water authorities, school boards, hamlets with bonds out there. Statistically, across the board they're all AAA rated, but any one of them could be a real risk.
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