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Wisconsin case could undermine credit-default swaps Print E-mail
Friday, 26 March 2010

By Ronald Fink

A recent court decision approving a Wisconsin insurance regulator's decision to force Ambac Financial's counterparties to take losses on credit-default swaps could undermine the value of such derivatives, according to a bankruptcy expert.

The decision by a state court is designed to prevent claims on swaps Ambac sold to Citigroup and other counterparties from driving the bond insurer into insolvency. The company has suffered severe losses on swaps it sold on mortgage securities that have gone south as a result of the collapse of the housing bubble.

But the court decision effectively voids contracts that federal law shelters from creditors' claims, Stephen Lubben, a law professor at Seton Hall University, wrote in a blog posted to Credit Slips on Thursday. If the decision stands and serves as precedent for other state rulings, that could call into question the validity of such swaps, Lubben wrote. And that could reduce their value.

Under the ruling, CDS sold by Ambac will be put in a segregated account and "rehabilitated" for the benefit of creditors and other stakeholders. Meanwhile, swaps holders will get as little as 25 cents on the dollar for their claims. Citigroup, for its part, reportedly agreed to the move because it has already written off much of the value of the swaps it bought from Ambac.

In contrast, counterparties such as Deutsche Bank, Goldman Sachs, and Societe Generale received 100 cents on the dollar for the swaps they bought from AIG, thanks to a taxpayer bailout after losses at the insurer threatened the financial system.

But Lubben said he expects industry lobbying groups such as the International Swaps and Derivatives Association to fight the Wisconsin court decision.

"The thud you just heard was ISDA's amicus brief arriving at the Wisconsin court," Lubben wrote.

He conceded that insurance insolvency is different from bankruptcy in some respects but questioned the legal basis for the decision, citing protection given to contracts by the US constitution. In response to pressure from the banking lobby, Congress provided credit-default swaps with a safe harbor under the constitution's contract clause as part of a bankruptcy reform law enacted in 2005. By exempting swaps along with other contracts from the so-called automatic stay of Chapter 11, the safe harbor shelters them from the claims of creditors and other stakeholders.

Lubben added that the ruling in Wisconsin poses practical problems for bankruptcies going forward. "If the segregated account is not a separate entity," he explained, "how do you put part of a company into rehabilitation and keep the creditors from going after the part that is 'out'?"

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