US CREDIT-Muni bond insurance may trump CDS policies

NEW YORK, July 15 (Reuters) - Protection sold by bond
insurers in credit default swap form may be considered more
junior than municipal bond insurance if an insurer is taken
over by regulators, in spite of language in the documentation
that states the two types of guarantees should be equal.

As a result, holders of protection in credit default swap
form may be motivated to seek payments before any possible
regulatory intervention occurs, which would be at the expense
of municipal bond policyholders, analysts at CreditSights
said.

And with the interests of municipal policyholders and
holders of credit default swap guarantees seemingly
diametrically opposed, litigation is likely to ensue.

"The implications of CDS not qualifying as insurance are
massive and we do not believe that they are fully understood by
the markets or the regulators," analysts Rob Haines, Brian
Yelvington and Craig Guttenplan said on Tuesday in a report.

Bond insurers sold guarantees on structured products backed
by mortgage and other debt, mainly to banks, in the form of
credit default swaps. This differs from insurance wraps the
companies also sold on municipal debt.

Rating agencies have cited insurers FGIC, CIFG and XL
Capital Assurance, part of Security Capital Assurance SCA.N,
as being at risk of falling below regulatory minimums that
could result in regulatory seizure.

FGIC's owners include mortgage insurer PMI Group Inc
(PMI.N) and private equity firms Blackstone, Cypress Group and
CIVC Partners LP. CIFG is owned by Banque Populaire and Caisse
d'Epargne, which together own French bank Natixis (CNAT.PA).

If the companies are take under regulatory control then
credit default swap claims would be considered subordinated to
claims by municipal policyholders under New York State law, in
spite of terms in the contracts that state they should be
ranked equally, CreditSights said.

Terms in the credit default swaps also state that a
regulatory seizure of a bond insurer, also known as a monoline,
would trigger the immediate payment of the protection.

However, because the law would subordinate their claims,
payments would instead be delayed by as much as 30 years as the
municipal insurance matures.

"Absent some action by state regulators to classify CDS as
insurance, which seems unlikely at the moment, recovery under a
rehab event could be as low as zero," CreditSights said.

"We think a run on a bank scenario at many of the monolines
is possible as structured investors try to queue up ahead of
the municipal policies," they added.

SECURITY OR INSURANCE?

"The regulator has indicated that he would likely pursue a
strategy that would be more sympathetic to muni bondholders,
rather than structured finance," in the event he takes
supervisory control of an insurer, said David Havens, credit
analyst at UBS.

" But it's not clear that that's going to be legally a
successful strategy," Havens said.

"In this case you've got what were sought to be iron clad
contracts that explicitly rank financial guarantee holders
executed in CDS form on the same footing as other holders, so
there would be litigation," he added.

Before it gets that far, however, there is still the
opportunity for banks holding credit default swap protection
and bond insurers to negotiate "commutations," or terminations,
of some contracts.

"Regulators are talking to banks and bond insurers about
commuting some contracts, with the intention of relieving the
insurance companies of the riskiest liabilities and allowing
banks to mark their monolines positions with some degree of
certainty," Havens said.

Regulators are also understood to be considering changing
credit default swaps used by insurers to guarantee securities
into insurance policies under the law.

New York insurance superintendent Eric Dinallo said in May
that it may make sense to regulate segments of the credit
derivatives market as if they were insurance products. For
details, see [ID:nN12297430]

"We have heard from a few sources that New York State is
considering amending the current insurance law in order to
define CDS as insurance," CreditSights said. "If successful,
CDS would be considered insurance and there would be no
acceleration in the event of a regulatory seizure, thus
avoiding the doomsday scenario."
(Editing by Leslie Adler)