Ambac regulator threads CDS needle
Cross-posted from today’s NYT.
Wisconsin’s insurance watchdog is requiring holders of credit-default swap contracts written by Ambac Financial, the troubled bond insurer, to take losses. It suggests what might have been done with the American International Group in different circumstances.
Ambac got into trouble selling CDS protection on what proved to be toxic mortgage-backed bonds. As those bonds have gone bad, the protection buyers have been demanding payments — and receiving them in full, to the tune of $120 million a month. 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. Some holders of CDS contracts won’t be happy. They were supposed to get paid quickly even if Ambac ended up in rehabilitation. But others, including banks like Citigroup, are thrilled with the deal as they’ve already written off much of their exposure. Now they’ll get a little cash back.
New York’s former insurance regulator, Eric Dinallo, similarly negotiated big haircuts with CDS counterparties of monolines he regulated. He brokered a deal between XL Guarantee and Merrill Lynch, for instance, where Merrill took 13 cents on the dollar in exchange for tearing up CDS contracts. But AIG’s counterparties were notoriously paid out in full following the government’s 2008 bailout. The reasons include the complexity of the giant financial and insurance conglomerate and the fact that Tim Geithner’s Treasury and AIG’s various regulators lacked the legal power to dictate a wind-down.
Reforms working their way through the U.S. Congress are designed to give watchdogs that kind of power. Had they had it back in 2008 — along with the guts to take control of AIG’s massive book of bad assets at the peak of a crisis — the course of the bailout, and even the crisis, might have been a lot different.