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Defaults: Ambac crisis provokes bankruptcy puzzle

Seizure highlights lack of clarity over what constitutes a default.

When Wisconsin insurance commissioner Sean Dilweg announced in March that he had taken over control of Ambac Financial Group’s $35 billion structured finance-related contracts in order to "protect policyholders, including investors in thousands of state and local municipal bond issues" the implications should have been reasonably clear. The regulator immediately received court approval to halt claims payments on the assets (roughly $120 million a month) for March. The insurer paid out claims of $1.4 billion against this exposure last year.

The move by the regulator essentially commutes Ambac’s CDO of ABS book. However, Ambac stated clearly that it did not believe that this segregated account rehabilitation constituted an event of default.

But others were not so sure. As soon as the news broke of the regulator’s seizure of the assets on March 25, UBS filed a request to the International Swaps and Derivatives Association to determine whether a bankruptcy credit event had occurred with respect to CDS written on Ambac Assurance Corp.

A regulator seizing liabilities on which payments are due and imposing a moratorium on such payments looks very like failure to pay or a moratorium credit event under Isda definitions. But as the assets have been moved into a segregated account any moratorium is on that account, not on Ambac itself. Analysts at CreditSights declared that they "tended to agree" that the segregated account rehabilitation did not constitute an event of default – that would only be triggered by the seizure of Ambac Financial, Ambac Assurance or a substantial part of the company’s property.

Just one day later, however, prompted by the UBS request, Isda announced in a brief press release that a bankruptcy event had occurred on Ambac Assurance Corp, and that an auction will be held to settle the CDS. It did not elaborate as to why.

It is quite incredible that an event such as regulatory seizure of assets can prompt such head scratching. The monolines were among the first to be hit in this crisis, and Ambac has been viewed as circling the drain for months. The state regulator took over the assets in the belief that "immediate action is necessary to address Ambac’s financial position". The firm has said that it is prepared to consider a prepackaged bankruptcy although it claims to have sufficient liquidity to take it through to the second quarter of 2011. It missed filing its 10K in late March.

There are roughly $3 billion outstanding CDS written on AAC. The Isda determinations committee has 15 members and apparently they voted unanimously that a bankruptcy event of default had occurred. It would be nice if this level of clarity existed in the wider market as well.

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