Saturday, February 16, 2008 5 comments ++[ CLICK TO COMMENT ]++

Splitting Bond Insurers: The FGIC Case

The biggest news in the monoline world right now is the notion of splitting the muni bond business from the structured product business. I'm sure that everyone, especially anxious shareholders, have been contemplating this scenario. I personally think Ambac is unlikely to seperate the muni bond business from the structured product business (but I can be wrong). The government would have to force the situation or at least provide some compensation (to the structured product insurance buyers).

In general, I think the splitting strategy is quite dumb and simplistic. I don't really know how one can discriminate against those that bought insurance on the structured products. One should also remember that structured products are not subprime residential real estate assets alone; they also include ABS of credit card loans, student loans, auto loans, commercial real estate, and so forth. There is going to be all sort of collateral damage to the educational institutions, auto retailers, and others, who benefit from secrutizing their debt.

I think we can be certain that the structured product side will go into run-off (liquidation/bankruptcy) right away so insurance buyers of those products will seek compensation via litigation. The State of New York is willing to step in front and provide cover for the lawsuits but even they may lose in the end.

The FGIC Case

In any case, FGIC, the 3rd biggest monoline and generally considered the weakest of the top 3 (although Fitch downgraded Ambac long before FGIC), is voluntarily pursuing a break-up. I highlight the voluntary element because this implies that the shareholders of FGIC, PMI and Blackstone, have calculated that the break-up maximizes their shareholder value. My guess is that if the monolines don't have to pay out any damages from lawsuits (either the government pays or no one does) then splitting may make sense.

The break-up will set a precedent (AFAIK monolines have never been able to do what is being considered now). Let me pick some insightful thoughts from a Fortune article on the FGIC story.

The plan, which appears to be unprecedented in modern financial history, seeks to separate FGIC's profitable municipal insurance business from its collapsing structured product insurance operations. Details were scarce Friday, but top Wall Street executives said the move was aimed at protecting the steady cash flows from FGIC's muni bond unit from burgeoning defaults and downgrades in the firm's risky and massive structured product portfolio...

FGIC insures about $45 billion of the $425 billion worth of municipal securities on the market. By way of comparison, its structured product portfolio insured about $42.3 billion in investments as of Sept. 30.

It's hard to say anything until some details are worked out. I'm not sure who will be calling the shots in a break-up. Will it be the monolines or will it be the regulator?

Many Wall Street traders were befuddled by FGIC's move and the massive losses it could cause investors who bought mortgage-related securities backed by the insurer. If FGIC were to split up, under Wall Street's convention, that would trigger an automatic pricing re-valuation of every bond that the firm had guaranteed. But with the collateral behind many of these bonds trading between no more than 20 to 40 cents on the dollar, billions of dollars worth of securities would be forcibly sold or valued lower, causing massive losses.

If I'm not mistaken, the buyers of insurance--mostly investment banks and hedge funds--have not marked down much for the top 3 monolines, MBIA, Ambac, and FGIC. Unlike the situation with SCA, which never had a AAA rating and hence was always viewed as a riskier smaller player, FGIC-related markdowns will be the biggest seen yet.

Isolating the company's structured product portfolio would, at least in the short term, likely create more problems for FGIC. Thousands of investors in structured products backed by FGIC would likely sue the company over the move...

Traders on Friday also questioned whether FGIC's proposal is legal. Regulators have a duty to protect the municipal bond market, but it's unclear whether they have the right to take such drastic action - or, as one Wall Street executive whose trading desk has exposure to FGIC-insured mortgage-backed securities put it, "carve up a corporation's cash-flows."

One hedge fund executive - who has longstanding profitable bet on the decline in the value of bond insurers' debt - said that the legal documents providing insurance to collateralized debt obligations (CDOs) and other structured products clearly state that they have a primary claim on FGIC's cash flows. "This isn't going to be so easy," said the manager.

I don't think FGIC will entertain this solution unless it was provided cover by the government. The lawsuits won't be handled for many years in my opinion. From a shareholder point of view, the company will be bankrupt or fully recovered by the time any of these lawsuits are finished.

One big question mark is how the rating agencies will look at this strategy. If they don't give a AAA rating, even after handling the capital needs, for the muni bond business, then this plan accomplishes nothing.

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5 Response to Splitting Bond Insurers: The FGIC Case

February 16, 2008 at 4:01 PM

FGIC's announcement has got to striking all SF counter parties with a serious case of the cramps. In the case of Ambac, I believe one of their top exposures is to Countrywide paper(?). How does that affect Bank America? Or is it a non factor?

I think it is still way, way too early. People are still in freak out mode. Although, if a split were to occur, either voluntary or forced, it would be much better handled, ironically, thru private hands rather than Fed or state regulators.

Cramer last night once again pushed the idea of forced bankrupty thru a Federal takeover and, talking with Spitzer, parrotted Bill Ackman by demanding Spitzer shut down div streams between insurance and holdco. I think Spitzer caught Cramer off gaurd, however, when he mentioned that he had shut down some of those divs as early as a year ago (I'll have to check the transcript when it's out). What is interesting is that when Spitzer was asked by Kanjorski why those divs had not been completely shut down Spitzer pretty much got in Kanjorski's face stating "excuse me, this is a publicly traded company.." The whole broadcast is archived.


February 16, 2008 at 4:07 PM

Another point, Eric DiNallo is still vying for private solutions. He will, of course, do what is necessary in the end given his regulatory position but it does not hurt that he was a Morgan Stanley executive in a previous life.

A poster on the new Yahoo MBI/ABK group - you should check it out, some really smart folks - brought up the 1992 "good bank/bad bank" split of Mellon Bank, which turned out to be a huge success. Interestingly, one of the big investors, who suffered thru some stomach churning moments, was Warburg Pincus.

February 16, 2008 at 4:24 PM

Mellon Bank turnaround story. Page 6 for dealing with regulators, page 8 where Warburg comes in and creates a "bad bank"

Another interesting side note - one of the brilliant turnaround guys that were brought in to save Mellon was Anthony Terraciano, who once headed Riggs, is now heading Sallie Mae (in case you wanted to look at other distressed entities).


February 16, 2008 at 8:12 PM

CAK: "FGIC's announcement has got to striking all SF counter parties with a serious case of the cramps. In the case of Ambac, I believe one of their top exposures is to Countrywide paper(?). How does that affect Bank America? Or is it a non factor?"

I don't think it impacts Countrywide or whoever else originated the underlying asset. The impact will be on the buyer of the insurance, which is generally banks, hedge funds, investment funds, and so forth.


As for Cramer and others trying to cut off dividend payments, it just goes to show that they don't know what they are talking about. First of all, the dividend amounts are so small to be almost irrelevant. Secondly, MBIA just raised a few billion and pumped it into its insurance subsidiary. It didn't have to do this and it seems ridiculous to talk about a few hundread million coming to the holding company while a few billion is being sent back to the insurance subsidiary. Maybe Cramer et al should bring up the issue when a few hundread million mean something in a few years. Right now, it has little impact on anything.


Reorganizing a bank may be easier than an insurance company. The problem I see is that the structured product side will be extremely weak after any split. I mean, it'll literally go into run-off right away.

The rating agencies will also likely take a very negative view of the seperated structured product entity.

It's hard to say anything since it is all hypothetical. My feeling--and it's only a feeling without any solid facts--is that a combined entity is stronger and will be able to handle potential losses better. Assuming hte legal issues are handled (by the state), the only way this split can work is if, as Michael Callen pointed out, the investors willing to invest in the muni side may have materially different risk profile from the structured product side. In other words, if you can attract capital at VERY LOW COST on the muni side then you can give almost all the existing capital to the structured product side. But one has to be sure that investors are lined up before any split is seriously considered.


CAK: "...Sallie Mae (in case you wanted to look at other distressed entities)."

I'm sure you also saw the bullish write-up at Accrued Interest (he likes the debt and not necessarily the equity). I think I have my hands full with Ambac for the time being :) I have indirect exposure to student loans through the Ambac exposure. If Ambac makes it out alive, student loans are its next big risk (along iwth auto loans)--although these are small compared to the subprime RMBS CDO-squared problem.

As for beaten down stuff, I'm looking at other industries like retailers, home building material suppliers, and the like. Although everything is impacted by housing, I think those provide some diversification. The difference between those and these finacial companies is that they won't necessarily go bankrupt (at least the big ones with strong brands).

February 18, 2008 at 10:44 PM

If you liked Ambac before, you've got to love it now. If the story in the WSJ is accurate, you will have a chance to triple your position at a discount to the market in this rights offering. The company is inviting you to back up the truck. Just keep an eye out for the pot holes behind you.

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