Bankruptcy

Ambac & the Safe Harbors

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that has some implications for those of us who think the safe harbors for derivatives in the Bankruptcy Code should be repealed, and replaced with more narrowly tailored provisions.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.

Full post as published by Credit Slips on March 25, 2010 (boomark / email).