Let’s say you file a claim with the insurance company after a disaster. Instead of getting a check, the insurance company tells you that it would prefer NOT to pay the claim since that would put the insurance company in a precarious financial position. What would your reaction be? Some banks are confronting a similar question with their CDS insurance.
Bond insurers such as Ambac, MBIA and FGIC are talking to banks about wiping out $125bn of insurance on risky debt securities in what could be the only way to limit the damage surrounding the bond insurers.
Discussions about “commuting” these insurance contracts, which were sold by bond insurers to banks in the form of credit default swaps, have taken on a renewed sense of urgency amid a rash of ratings downgrades in the bond insurance, or monoline, sector last week.
If agreements are struck about the value of the CDS contacts – and the discussions could take months – it could be significant for the entire financial system, which is clogged up by the uncertainty around the value of derivatives and complex bonds linked to mortgage-backed securities.