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Ambac & the Safe Harbors

posted by Stephen Lubben

Ambac, the former municipal bond insurer who decided it would be fun to write CDS on mortgage backed securities, has entered into an interesting arrangement in Wisconsin, that has some implications for those of us who think the safe harbors for derivatives in the Bankruptcy Code should be repealed, and replaced with more narrowly tailored provisions.

As I understand it, Ambac's insurance subsidiary has created a "segregated account" comprised mainly of its CDS contracts on collateralized debt obligations. Next that account has been placed into a rehabilitation proceeding by the Wisconsin insurance regulator, who has asked the State court for an injunction to prohibit the CDS counterparties from exercising their rights to terminate, etc. under the ipso facto provisions in the contracts. The State's brief pointedly notes that Wisconsin insurance law, unlike the federal Bankruptcy Code, contains no safe harbors for derivatives and that it will be impossible to unwind Ambac's contracts in a considered manner if the ipso facto provisions are enforceable. (The thud you just heard was ISDA's amicus brief arriving at the Wisconsin court).

I obviously share the concern that safe harbors make it near impossible to conduct an orderly reorganization or liquidation of a counterparty, and often increase the disruption to the financial markets as everyone rushes to close out and reestablish positions. But I have some concerns about the Ambac approach. For example, what is the legal basis for the "segregated account"? If it's a separate legal entity, do the CDS counterparties have an argument that their contract has been novated (i.e., assigned) without their consent? That could be a problem. If the segregated account is not a separate entity, how do you put part of a company into rehabilitation and keep the creditors from going after the part this is "out"?

I know insurance insolvency is different from bankruptcy, but the more I think about this, the more questions I have.

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Comments

Yah. "Protected cell" companies are a common wheeze in the insurance world. The idea is to create a non-insurance subsidiary, but keep it out of the Code by saying that it is part of the insurance entity, albeit with distinct assets and liabilities.
I didn't know that these things could switch liabilities around the cells at pleasure. Yuck.

Looks like other lawyerly folks find this situation interesting as well:
http://seekingalpha.com/user/519327/instablog

When does this become fraud? (Either constructive fraudulent transfer or the garden-variety forms of debtor/bankruptcy fraud?)

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.)

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.

Insurance companies can't file under the Bankruptcy Code - their involvency/rehabilitation/conservatorship/liquidation procedures are handled by the insurance commissioner of their state of domicile - so the swaps exceptions don't apply in the rehabilitation of an insurer. The commissioner normally looks for guidance to bankruptcy law, but the same reasons of public policy that exclude insurance companies (and, for that matter, banks) from bankruptcy mean that he's not bound by the Code and is free to reject the 2005 amendments favoring derivatives.

As for the segregated account, it's provided for by Sec. 611.24 of the Wisconsin Statutes. Many other states have similar provisions, as does Bermuda. This is an unusual use of a segregated account, but then it's an unusual situation.

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