Bond Insurers Looking to Unwind $125 Billion in CDO Contracts

The latest twist and turn in the wake of now widespread bond insurer downgrades is that some of the largest — notably MBIA Inc. (MBI: 3.96 -5.94%) and Ambac Financial Group, Inc. (ABK: 0.88 -5.38%) — are looking to essentially wipe out $125 billion in insurance on collateralized debt obligations tied to subprime and other mortgages that have likely gone permanently bad.

The insurers are looking to commute a series of credit default swaps that served to wrap CDO deals that have since plunged in market value, according to a report in the Financial Times — although bond insurers have repeatedly asserted that actual loss experience is far less severe than market pricing would suggest.

Commutation would involve the policyholder receiving some fixed payment in exchange for tearing up the swap agreement; essentially, the investment bank counterparty would release the insurer from its guaranty in exchange for a cash payment from the insurer for so doing. But for many banks the risks of unwinding contracts could be as much or greater than simply holding onto the swap, sources told HW, since any bank that agreed to unwind a CDS contract would be forced to take some pretty toxic CDOs onto its balance sheet.

“If firms and their counterparties can get across the finishing line in their commutation negotiations, a shadow of uncertainty would be lifted from the monoline sector, with the prospect of better rating stability,” said Matthew Elderfield, chief executive of the Bermuda Monetary Authority, which regulates a number of bond insurers.

Yves Smith, a well-known financial blogger who writes at Naked Capitalism, says that while the proposal may work for both parties in a swap — after all, banks are now essentially paying AAA rates for an A-rated policy — whether the bond insurers can wipe off their liabilities around CDOs of ABS remains to be seen.

“The banks may push hard, assuming insurer desperation, and may also be angry with being stuck with a turkey product,” she writes. “Insurers are notably pig headed negotiators.

“While in theory there should be a win-win resolution for at least some of these contracts, if the tone of discussion becomes adversarial, all bets are off.”

Disclosure: The author held no positions in publicly-traded firms mentioned herein when this story was originally published. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.