CDS Counterparties Hoist on Their “Not Insurance” Petard

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.

Schadenfreude, no?

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  1. Bruce Krasting

    So AMBAC is becoming another AIG. And this is being used as a “I told you so” moment.

    The problem is that both of these dogs are and were regulated entities. This was a fault of the regulators that AMBAC got in so deep they have no exit. When regulators fail and there is a problem it becomes systemic. When regulated entities fail the public sector has to bail them out.

    That will be the case with AMBAC. The states are too troubled to issue debt without a viable muni guarantor. So AMBAC must live. And we will pay.

    These is not an example of how bad CDS is. It is an example of people buying CDS from a regulated entity that did not have the capital strength to live up to its obligations.

    I means we have not learned a thing from AIG.

    1. Claire

      ” When regulated entities fail the public sector has to bail them out.

      That will be the case with AMBAC. The states are too troubled to issue debt without a viable muni guarantor. So AMBAC must live. And we will pay.”

      Sorry, Bruce, but I’m a little slow here.

      (1) Why subsidize the middle man (AMBAC) and let them take their cut instead of subsidizing the states (guaranteeing their debt issuance) directly?

      (2) Even if AMBAC gets bailed out, how does this change anything, since everybody knows that AMBAC is dependent on the State for survival? The guarantee becomes, essentially, a state guarantee anyway.

      This might be obvious, but it’s not rhetorical–I’m just a little slow.

    2. sgt_doom

      Sorry, Bruce, but no such thing, dood!

      It’s the fundamental regulations, or lack thereof, as Ms. Smith infers.

      THE CDS — which you either don’t fully understand or are covering for — is simply a Ponzi-Tontine creation. Great for doing bear runs and profitable destruction, lousy on all other counts.

      Nothing will ever change the reality on this matter.

    1. Gus

      Another weird aspect of insurance liquidations — many or most aspects of state liquidation law are considered to reverse-preempt federal law under McCarran Ferguson, making the characterization of CDS by congress less than determinative when that characterization conflicts with state rehab/liquidation law.

  2. bandarlogician

    There may be some Ambac entities that could “file for bankruptcy” in the way we normally think of it (i.e., chapter 11), and the rules tend to be ignored or re-written when the stakes are high enough, but insurance companies are generally prohibited from seeking federal bankruptcy protection under section 109 of the code.

    Insurance company insolvency is governed by state law (see here:

    That probably doesn’t change the basic premise that policyholder claims come ahead of other contract claims, but this esoteric are of state law may result in some interesting twists and be less predictable than bankruptcy.

    1. Gus

      Right, the insurance entities would get wound down under state law, not federal BK law. Under almost all state’s rehab/liquidation laws, policyholder claims come third after secured creditors and administrative expenses, with general unsecured (e.g., CDS holders) next after that. Liquidations of national businesses are like the wild west, as the state liquidation court does not really have extra-jurisdictional power, but rather has to rely on other courts to enforce reciprocity provisions in sister-state laws (where available) or comity (unlike an order from a BK court, which is given full force and effect throughout the country). You likely would have parallel proceedings with non-insurance entities in a BK court, but insurance regulators typically do a good job of ring-fencing assets in the insurance entities leaving less assets for the BK court to handle.

  3. Larry Headlund

    That should be “hoist by their own petard” not “on”. Think “hoist” (blown up) by their own “petard” (slang for hand grenade) although blown by their own (literal meaning of petard) isn’t a pretty picture either.

  4. Siggy

    Schadenfreude Ja!

    To the buyers, if you want your CDS to be executory contracts, so be it. To the sellers, you want your CDS to be executory contracts, so be it.

    Now, you buyers have before you events stipulated in your executory contract. The seller is constrained because performance would impair his ability to honor insurance contracts.

    At law, the insurance contracts are superior claims. Dear Dear Buyer of CDS, you are entitled to a haircut.

    And you Dear Dear Seller are entitled to liquidate your otherwise profitable municipal bond insurance business.

    Think about it, CDS are nothing more than speculations made by two parties that something will or won’t happen. Shouldn’t there be a law/regulation that holds that the seller of insuance may not speculate?

    And, shouldn’t there be a law that holds that an individual or a corporation may not enter into a contract who terms they cannot honor?

    We can be accomodating and say that mistakes were made as to the assessment of risk; or, we can see that there is fraud afoot. Put another way, there ain’t no free lunch and those CDS premia were chump change.

    1. sgt_doom

      “Shouldn’t there be a law/regulation that holds that the seller of insuance may not speculate?”

      Why yes, there were once upon a time, but thanks to the Private Securities Litigation Reform Act of 1995, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, and the Commodity Futures Modernization Act of 2000 (which we learn from Yvs Smith’s book, ECONned, Mark Brickell, formerly with the International Swaps and Derivatives Association, wrote much of) removed them.

      “And, shouldn’t there be a law that holds that an individual or a corporation may not enter into a contract who terms they cannot honor?”

      Ahhh…Contract Law 101….and that pesky Federal Reserve Act, which none of those chairs of the Fed ever seem able, or capable of, enforcing.

      1. sgt_doom

        Forget to mention the Law of Fraudulent Conveyance, on the books on many states, dating back to the 1700s and 1600s.

  5. MichaelC

    Yesterday’s Maiden Lane release includes this nugget.

    Maiden Lane I is long protection on the monolines, MBIA, FSA and Ambac.

    Yikes, the FED has a conflict with Wisconsin.

    1. cas127

      Exactly, MichaelC.

      Yves gets excited about rightful revenge and says…

      “The mortgage-backed securities for which *they* bought protection are going bad now”

      but considering that the Fed holds well over $1 trillion in MBS, doesn’t it make sense that “they” now includes a helluva of a lot of “us” (the US taxpayer and holders of Fed-debased dollars)?

      *Annnndddd*, as noted elsewhere, we can also look forward to Round 2 of “Ignore-the-Inconvenient-Law” on the part of the Feds (Round 1 was the rape of the secured lenders in the Auto Bailout/Ripoff/Political Bribe) as the 2005 bankruptcy amendments favoring derivative counterparties are shat upon by our “government of laws”.

      Yes, we are so well and faithfully led – and NYC harbors the only villains…

      Burn down the Money Center oligopoly…but incinerate our gerrymandered political kleptocracy as well.

      1. Yves Smith Post author

        You are wrong re applicable law, and therefore in your assertion that the state regulator (you seemed to have skipped that part too, in asserting that this is “Feds”; insurance has ALWAYS been regulated at the state level in the US.

        The muni insurance was written at the subsidiary level. The CDS was written at the holding company. Insurance subs don’t go into bankruptcy (there is a different legal term of art, and a different regime). So the CDS holders ALWAYS sat behind the insurance contracts had anyone bothered to investigate the CDS counterparties and how they are regulated (and that’s before you get into the issue Rolfe raised). This is the exact reason why the AIG CDS were no good, the CDS holders could only look to holding company payment power, the ability of the subs to dividend up to the holding company is severely limited.

        1. cas127


          I think you misread what I said – I made no assertion that Fed regulation of insurance companies was involved in anything.

          My point was that before getting too excited about sticking it to the counterparty banks by cavalierly ignoring the 2005 BK amendments, it might be well to reflect upon the fact that since the Fed (backstopped by the Treasury – ie, us) now holds over $1 trillion in MBS (which I would think has a helluva of lot of CDS protection built into it) it might not be such a wonderful thing for counterparties to be dealt with lawlessly.

          Otherwise the Fed/Treasury/Taxpayers might be deprived of counterparty protection they are otherwise entitled to.

          As for the bulk of the assets being at the insurance sub level, I have no reason to disagree with you.

          And I didn’t.

          I did say that the 2005 amendments should not be trashed the way secured bondholder protections were trashed in the Auto Union Bailout.

          The point of my post what that an over-eager desire to exact justice against the banks should not lead to the disregard of established laws.

          Because less-stained counterparties rely upon those laws as well.

          And once laws are easily disregarded, they are often disregarded for political reasons (Auto Union Bailout).

          *And*, my guess is that *somebody* is at least a *little* concerned about some court taking a jaded view of the treatment of counterparties here, otherwise

          1. Yves Smith Post author

            Not only do you not read what I wrote, you disavow what YOU wrote. Your earlier comment did invoke the Federal government: “Round 2 of “Ignore-the-Inconvenient-Law” on the part of the Feds…”

            You are missing the critical point here. BK law does not apply to state regulated insurance subsidiaries because insurance operations are not resolved through a bankruptcy process. The 2005 laws were devised with an LTCM scenario in mind, of a hedge fund vs. its dealers. Not only was it not drafted with an insurer in mind, I doubt it could reach there anyhow (this is a jurisdictional matter).

            The affiliate that wrote the CDS could conceivably be put into BK, but that would not accomplish much, since it is due to run out of dough in about a year and cannot reach into the insurance subs, which are state regulated and not subject to a bankruptcy process.

            So the law is not being violated here, as you incorrectly assert. It isn’t terribly germane in this circumstance.

            Update: Realty based lawyer later in the thread provided further clarification. The contracts were not CDS, hence your derivatives point is again moot.

      2. MichaelC


        I meant to draw attention to the irony of the FEDs conflicts of interest with the State of Wisconsin regulator’s goal. To maximize the value of ML, the Fed is incented to get maximum payment on the protection. The FEDs ML position is now a factor in Wisconsin’s effort, since ML is long protection on AMBAC.

        The FED has a direct interest in the case and they’re perversely incented to block efforts renegotiate CDS payments.

  6. psychohistorian

    I don’t understand why the CDS holders are being offered 25%. Why are they being offered anything? Does the existence of derivatives automatically rewrite all of law to coddle them and their holders? WHY?

    1. MattJ

      The CDS holders are entitled to the assets of Ambac beyond what is required to back Ambac’s insurance policies. They have actually been paying Ambac for their swap, just not enough to cover their losses. The 25% is the expected value of Ambac’s assets beyond what is needed to back the insurance policies.

    2. cas127


      Well, the 2005 bankruptcy amendments favoring derivative counterparties make a very strong case that CDS holders *do* go to the head of the line in BK.

      But, hey, that’s just a little “law”…

      Of course, we can all just ignore the inconvenient laws like we did when the Administration raped the secured lenders in the auto bailout/union payoff.

      And before you get all exercised about how, you know, actually *following* the law would only benefit the banks (who I have no love for either), recall that our paper-spewing Fed now holds well over $1 *trillion* in MBS (at least some of which I have to imagine is protected by CDS).

      1. Yves Smith Post author


        I suggest you bother familiarizing yourself with the facts at hand, rather than making erroneous and unfounded assertions, per my comment above. Your little “law” applies h isn’t germane here. This is not a matter of overriding existing law, it’s a matter of the counterparties not doing their homework on what rules were applicable. See my comment earlier and Realty-based lawyer below.

  7. Hugh

    I am coming to the view that all CDS are inherently fraudulent and should simply be nullified as should happen in such a case. Denninger has touched on this. Because of the high leverage, there were never the funds to pay out on CDS. Both sides knew this. This knowledge does not mean there was no fraud, but rather that both parties engaged in it for their own purposes.

    Yes, this would mean we would have to put most of the financial system into receivership, but we can either try to do this in a controlled way or in an uncontrolled one via another collapse.

    1. MattJ

      Hopefully that would include the CDS seller returning the payments from the CDS buyer, including interest.

  8. Calinvest

    It sure is a relief to GS shareholders that Jamie Dimon got a 100% payoff on AIG CDS from the US Govt before this dustup emerged.

  9. Mark

    Do you know how the credit protection was executed? Specifically, does Ambac Assurance (the regulated insurance entity) enter into credit default swaps directly with counterparties, or does a capital markets subsidiary of Ambac enter into a CDS that is guaranteed by Ambac Assurance? I thought it was often (perhaps always) the latter?

    In this case, it would seem that the banks would be correct in arguing that the contracts are CDS, rather than insurance (and therefore outside of Dilweg’s purview).

    I am sure your friend Tom Adams must know the answer to this; however, I also think it is almost entirely an academic question. Regardless of whether funds were segregated or not, Dilweg would have every right to cease payments. This is needed to protect policyholders, so this is part of his job. The countparties might argue that the segregated account is unfair, but this seems like a long shot (Tom Adams, what do you think?), it could take years to litigate, and there is no way they will collect 100 cents on the dollar anyway. Their economic position is probably not much different than if they settle and take cash and surplus notes.

  10. Realty-Based Lawyer

    I was general counsel of two bond insurers. The bond insurers didn’t write CDS. They guaranteed, through standard bond insurance policies, CDS written by an affiliate, as specifically permitted by letters from the NYSID (NY State Insurance Department). The policies were no different from other policies; they were insurance contracts. The CDS guaranteed by bond insurers were structured to mimic cash MBS and ABS as closely as feasible. (Bond insurers even had control rights, normally required physical delivery of the underlying bond and if rated AAA refused to post collateral.)

    The problem in this case isn’t the CDS form, it’s that the underlying assets went south.

    There’s also a technical difference that the bond insurance policy covered the affiliate CDS writer’s obligation to make termination payments, but again those were different from “standard ISDA” arrangements. And, because all bets are off in insolvency, the opinions given by bond insurer counsel excluded enforcement in insolvency or rehabilitation proceedings.

    AIG’s CDS were much more “standard ISDA.” Different animals, with additional risk just from being CDS (on top of the risk on the underlying bonds).

    1. Hugh

      The problem with CDS has always been about their form. They are bets when insurance issues are raised and they are insurance when gambling is the subject. As I said above, they were always fraudulent in nature. The money was never there either to cover the bet or pay the insurance. So no matter which hat the CDS is wearing at any given moment, it was a fraud under both scenarios.

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