A state court on Wednesday allowed the Wisconsin insurance commissioner to proceed with his plan to allow bond insurer Ambac Assurance Corp. to imminently settle claims owed to major banks on structured finance product transactions.

Critics say the decision will give those policyholders preferential treatment and could leave the insurer without adequate capital to pay other claims. The judge, however, said tearing up the contracts at a fraction of their original value would help stabilize the company and benefit all policyholders.

Under the agreement, Ambac would pay $2.6 billion in cash and $2 billion in surplus notes to commute, or cancel, credit default swaps with an original face value of nearly $17 billion. The counterparties are 14 of the world’s largest financial institutions.

“Absent a global commutation with the bank group, [the Wisconsin regulator] projects that [asset-backed security] CDO exposures are likely to experience the greatest losses of all Ambac exposures — materially greater than even the troubled RMBS book,” Dane County Circuit Court Judge William D. Johnston wrote in his 17-page decision.

Ambac Assurance is a junk-rated insurer that has not written new policies since June 2008. Before the credit crisis, it was triple-A rated and held the second-largest insured municipal bond portfolio in the market. But in late 2007, its financial position began deteriorating after it suffered near-fatal losses from guaranteeing residential mortgage-backed securities and other risky assets.

Some of the risky products Ambac insured took the form of CDS on collateralized debt obligations. The insurer was prohibited from directly issuing CDS, but it did so indirectly through a non-insurer subsidiary whose financial obligations it guaranteed.

Those obligations were front and center in the court hearing, as insurance commissioner Sean Dilweg won approval for Ambac to use its limited resources to settle those claims.

The agreement follows similar arrangements made in the past two years. In 2008, Ambac paid $1.8 billion to remove other impairments from its books, and in 2009 it paid another $1.4 billion in commutation payments, court documents showed.

“The steps we’re taking are aimed at avoiding billions of dollars of losses, and will provide the best way toward a durable solution for all policyholders,” Dilweg said in a statement. “There are very real and dramatic risks if the orderly process we are pursuing is not preserved.”

Johnston noted the CDS contracts allowed Ambac’s counterparties to seek mark-to-market damages that could increase with time. By settling the claims now, he said, Ambac would be acting in the interests of all policyholders to stabilize the company.

“Settling the growing, volatile ABS CDO exposures at a major discount inures to the benefit of all other policyholders by capping those exposures, eliminating the possibility of costly, slow-moving mark-to-market litigation that would reduce recoveries to policyholders in the segregated account, impair Ambac’s ability to provide continuing coverage to policyholders in the general account, and delay the ultimate resolution of Ambac’s financial situation,” he said.

Arguing against the plan were a number of mutual funds, including Eaton Vance and Nuveen Asset Management, representing holders of municipal debt issued by the Las Vegas Monorail Co., as well as several hedge funds holding residential mortgage-backed securities insured by Ambac.

The monorail debt and RMBS are each administered by the commissioner, who in late March took Ambac’s most toxic holdings and placed them into a segregated account.

Lawyers representing the monorail bondholders claimed in early May that the proposed settlement “could have a devastating impact on the rehabilitation of the segregated account of Ambac and cause irreparable harm to the rights of the LVM bondholders and other policyholders,” according to court documents.

Moreover, they argued that the obligations in question are distinct from insurance policies and should not be considered on the same level as Ambac policyholders, let alone elevated to a prioritized position or receiving imminent payment.

“Any amounts that Ambac would pay these banks would not be a reimbursement of their losses (they have suffered none), but instead would be the pure profit to them — the fruits of a winning wager,” they wrote.

They also said that the commissioner’s argument that the state has no right to review the settlement decision “flies in the face of Wisconsin’s rehabilitation statute, which expressly requires 'court approval’ for significant actions taken by a rehabilitator.”

Meanwhile, the court’s ruling to uphold the commissioner’s plan could be an auspicious sign for MBIA Inc.

In the Ambac case, Johnston noted regulators were working with Ambac on “essentially a daily basis” and that its “determinations are grounded in … literally thousands of hours of professional time.”

Since February 2009, MBIA has been making similar arguments as it battles to dismiss a number of lawsuits contesting the launch of National Public Finance Guarantee Corp., a muni-only insurer created by transferring capital away from MBIA Insurance Corp.

The New York Insurance Department, MBIA’s regulator, approved the capital transfer, but policyholders of MBIA Insurance claim the decision left the company bereft of adequate capital and they have been contesting the NYID’s ruling through the courts.

MBIA declined additional comment.

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