I’ve just put up a post which includes a lengthy discussion by the former general counsel of a bond insurer on the issue of CDS acceleration. Some of the ways things play out are a bit different than one might expect due to the peculiarities of how insurers are treated in the event of insolvency.

I agree with AnoninCA (and with most of etc’s comments), especially the point (AnoninCA’s third) that the ability to “accelerate” (or close out) derivative contracts as such doesn’t mean that unsecured CDS counterparties get preferential treatment in insolvency (or similar) proceedings. In such circumstances queue jumping becomes irrelevant: insolvency proceedings turn the queue into a group: the all-or-nothing of “first come, first served” is replaced by the proportionality of “all come, all served equally”.

The crucial issues are therefore (see also AnoninCA): (1) collateralization of derivative exposures on MBIA and (2) timing of close-out/acceleration.

Collateralization: I don’t know whether MBIA is required to post collateral under its CDS contracts. This may to some extent be prohibited under US/state insurance laws (on which I’m not an expert) or, even if that is not the case, an insurer may be averse to agree to collateralization, precisely because it would give its derivative counterparties an advantage (and in that sense: preferential treatment) vis-à-vis its policyholders. In addition, MBIA may have had sufficient bargaining power to avoid collateralization under its ISDA Master Agreements. I didn’t have time for more than a quick check of only part of MBIA’s 2007 Annual Report, but the report does say in relation to certain CDSs that MBIA does not post collateral. If anyone else knows more about this, it would be very interesting to hear from him/her.

Timing: AnoninCA also correctly indicates that the standard form of the ISDA Master contains many more close-out triggers than the Bankruptcy clause. In addition, CDSs are of course “privately negotiated” derivatives and MBIA and its counterparties (or some of them) may have agreed additional events of default and/or termination events. It is certainly possible that events such as a substantial downgrade of MBIA or its failure to comply with laws and regulations (capital requirement, for instance) would give at least some protection buyers the right to close-out their CDSs with MBIA and to demand payment of the replacement value of the CDSs long before MBIA gets even close to insolvency or take-over by the regulator.

1. If a derivative holder with a claim holds collateral (e.g. repos and netting of swaps), the derivative holder can take possession free and clear. Other creditors are subject to the bankruptcy court recalling the assets.

2. If a derivative holder has managed to get payment before the declaration of bankruptcy, the 2005 law (and previous amendments to the bankruptcy law) exempts them from having to return the money to the bankrupt estate. All other creditors can be forced to return recent payments to the estate.

3. Etc is right that once bankruptcy has been declared, each derivative holder is just one of many unsecured claimants.

The tricky issue is that most CDS have pre-bankruptcy acceleration clauses. I would guess that the NYSID is very well versed in these timing issues by now.

Those details of bankruptcy law are out of my ken. However, it seems likely that the regulator would seize control first; even more likely (well, if it were any insurer but MBIA, which seems to have a very bad case of denial) is that an insurer would go into voluntary runoff.

Having said that, there are very weird provisions of bankruptcy law regarding certain kinds of financial instruments. There would have been certain accounts (or was it exposures?) if Bear had BK’d that would NOT have been handled by a bankruptcy judge, I dimly recall a discussion of netting. Anyone who knows this area is encouraged to speak up.

And even if these CDS don’t give them a standing that trumps the bankruptcy process. the language on the MBIA website confirms their right of acceleration, which would seem to give them a priority in standing over other insurance policy holders.

I have been trying to reach a former general counsel of one of the bond guarantors on this issue. Unfortunately, he is a very intermittent correspondent. Since MBIA and Ambac seem likely to be in the press, I’ll probably have reason for more posts near term, and will include any further intelligence on this front.

I believe the bits of Felix you’re quoting refer to rules that affect the size of a counterparty’s claim in bankruptcy against MBIA, but does not give the counterparty a priority over other creditors, so it gets dibs on assets before they do. More importantly, one would have to consider the amount of discretion a bankruptcy court has over the MTM that determines the size of a counterparty’s claim. Bankruptcy courts are famous for screwing over particular creditors to make sure pain is shared by all.

In a conversation that Felix Salmon had with one Hampton Finer of the New York State Insurance Department, he did everything he could to avoid a straight answer, which I take as confirmation (more accurately, the subtest is “yes narrowly you are right, but we think it doesn’t have to play out that way”). From Salmon:

And what about this latest storm over MBIA’s credit default swaps being accelerated if the company gets taken over by its regulator? Well, for one thing, if MBIA goes below its minimum capital requirements, NYSID is not obliged to take it over. The regulator would of course step in if MBIA looked as though it was about to declare bankruptcy or otherwise have an event of default. But there’s a very long way to go before things get that drastic.

On the other hand, said Finer, “we believe there are ways of controlling those events of default”.

I believe Felix Salmon and you are wrong about this. To the extent a counterparty under a CDS with the MBIA regulated subsidiary has a position that has appreciated from inception to the time MBIA files bankruptcy, I believe the counterparty gets a general unsecured claim for that appreciation. And I believe the only way the counterparty would get a priority claim is for appreciation in its rights that occur after the bankruptcy, but even then only if the counterparty did not choose to terminate the contract and only if the bankruptcy court did not require MBIA to terminate the contract. Any such priority is weak gruel if the bulk of the appreciation in a counterparty’s long position under a CDS occurs before MBIA files bankruptcy.

There are select classes of creditors given priorities in bankruptcy, like certain claims for child support and alimony. If you run down the list of claims given priorities in Title 11, I believe you will not find something saying that swap counterparties get a priority for anything that happened prior to the bankruptcy filing.

Now, if the swap counterparties had contracts written by an entity other than the regulated sub, the swap counterparties may well have a priority over the policyholders with respect to the assets of the entity in privity with them. However, that is because of liability insulation arising from MBIA operating through separate entities, not from anyting in the bankruptcy code. And if the MBIA entities didn’t act appropriately with one another, then the bankrutpcy court might treat all the MBIA entities as if they’d been a single company, and undercut such liability insulation.

This lack of protection for CDS counterparties with respect to appreciation of their long credit protection positions is part of the reason why the Fed is so freaked out about credit default swaps. Some fund or bank operating out of a van down by the river and highly levered almost certainly is relying on CDSes to hedge other positions and will implode if its long positions under CDSes are vaporized because the counterparty goes bankrupt. If there’s enough people like that, the gross positions under CDSes actually matter because things do not net out.

And don’t tell me CDS holders get a priority for pre-bankruptcy appreciation because of 2005 amendments to the bankruptcy code. They do various other things, like fix certain netting and termination problems. However, they don’t fix this.

Now I have to get to sleep to wake up early for kindergarten. Anyone to relies on a kindergartener for legal advice is a nuts.