Further evidence of the dangers of dabbling in derivatives markets is emerging in the troubled bond insurance sector.
Bond insurers, from the troubled, such as FGIC, to the relatively stronger Ambac and MBIA, are immersed in complex talks with banks about whether there is any way the credit default swaps bought by the banks as insurance on risky deals can be torn up. In order to commute these contracts, bond insurers would have to pay banks an upfront fee.
The existence of these CDS contracts, around $125bn of which were written to guarantee payments on collateralised debt obligations, is making it impossible for bond insurers to move on.
On a practical level, without knowing how much will have to be paid out on these policies, investors cannot value the monolines or lend money to them, even if they think the likes of MBIA and Ambac could re-emerge as players in the municipal or project finance guarantee markets.
From the perspective of regulators such as the New York state insurance department, which has enormous power in the sector, whether such payouts are real could be a crucial part of their calculations about whether the insurers are solvent.
If weaker bond insurers such as CIFG are forced into “rehabilitation”, the insurance equivalent of bankruptcy, the holders of CDS contracts could join the list of creditors, together with investors holding bonds issued by local municipalities. Some banks may hope that this is a way to get some payout on CDOs, where values have plunged due to links to risky mortgages. There are no precedents for how CDSs should be treated. Yet regulators have made clear they care most about the municipal bond market. In any battle between Wall Street and Main Street, it is the latter regulators will back.
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