Rolfe Winkler has an useful sighting on a wrinkle in the Ambac receivership. A big bone of contention has been the credit default swaps that Ambac wrote on various structured credit transactions. While many of the contracts provided for considerably delayed payment (they were different in this regard from AIG’s CDS), as Ambac’s condition worsened, its obligations increased to about $120 million a month. That is enough of a cash drain to impair Ambac on an ongoing basis.
Enter Wisconsin regulator (Ambac is domiciled in Wisconsin). The regulator is trying to avoid putting Ambac into receivership, since the banks would argue that that was a credit event on their CDS and would argue for immediate payment. Here is the conundrum and the proposed solution:
The problem for the regulator was that this cash outflow was on track to drain Ambac dry, leaving other policy-holders with no protection. Since Ambac also insures lots of municipal bonds, the fallout could have been felt across the United States.
So Sean Dilweg, the Wisconsin insurance commissioner, is pushing the troubled CDS contracts and some other losing policies into a segregated account that his department will try to wind down, a process known as rehabilitation. Meanwhile he has secured court approval to halt the payouts Ambac has been making.
Part of the plan is to cut a deal with the CDS counterparties. Dilweg expects they’ll get cash worth about 25 cents per dollar of coverage. They’ll also receive so-called surplus notes which could eventually yield more if the rehabilitation works out.
Yves here. What is amusing about this (assuming the initial court decision stands, I’d expect some banks to mount an appeal), is that the status that the banks so keenly fought for, that of CDS not being regulated as insurance, is working out, not to their advantage. From a later post by Winkler:
Buyers and sellers of credit default swaps have long argued CDS are executory contracts, not insurance policies. For accounting purposes, for tax purposes, for not-holding-capital-against-their-positi on purposes, they want it to be treated like a contract. But this is problematic when the sellers of CDS — the Ambacs/MBIAs/other monolines — run into trouble and face bankruptcy.
Executory contracts are junior to insurance policies in bankruptcy. For an insurance company like a monoline, that means capital might be sequestered in order to protect policy-holders over the life of their policies. What’s left after policies lapse can then be paid out to other creditors.
The monolines were mainly in the business of insuring municipal bonds, insurance policies that can run for decades.
But CDS holders want their money now. The mortgage-backed securities for which they bought protection are going bad now, so they’re getting paid now. Nevermind that payments on these CONTRACTS would wipe out what’s left of Ambac’s capital needed to back its municipal bond INSURANCE POLICIES.
Yves here. So in other words, even if the banks tried the nuclear option of demanding immediate payment, the odds are high that in a bankruptcy court, their CDS claims would be deemed to be junior to municipal bond insurance.