Thursday, February 21, 2008

A 'Simple' Bond-Insurance Plan

The Complex Risks of Dividing

Businesses to Avert Downgrades

February 21, 2008; The Wall Street Journal, Page C2

Everyone seems to have a plan to fix the problems of Wall Street's struggling bond insurers.

From Warren Buffett to state insurance regulators to stock market short sellers, the many rescue plans being floated around for MBIA Inc., Ambac Financial Group Inc. and FGIC Corp. offer variations on a similar theme.

They want to separate the industry's safer business of insuring municipal bonds from the riskier business of covering securities backed by, among other things, subprime mortgages, in essence splitting the insurers in two, creating one good and one bad.

Each plan, in turn, is fraught with complications and contradictions.

The latest to offer up a plan yesterday was hedge-fund manager William Ackman, head of Pershing Square Capital Management LLC, who has long bet against bond insurers and their shareholders.

Here is a rundown of what is in play:

Q: Why are bond insurers in so much trouble?

A: They face big losses, and their top-notch credit ratings, critical to their ability to do business, are threatened. The housing slowdown means investments tied to mortgages they insured could default, leaving them on the hook to pay out billions. Credit-rating services threaten downgrades, which would raise their cost of funds and hurt the value of the bonds they insure.

Both Main Street investors, who have ordinary municipal bonds, and Wall Street banks, which hold the more-complex securities, could see their holdings plunge in value if the insurers behind them are downgraded.

Q: What is this idea of splitting bond insurers in two?

A: FGIC, one of the major bond insurers, has requested that regulators allow it to set up a new firm that would insure municipal bonds exclusively -- in essence, a "good bank." Ambac Financial Group, which owns a small bond insurer called Connie Lee Insurance Co., says it could use that unit's licenses in 47 states to quickly undertake its municipal-bond insurance business.

These steps would effectively force the struggling units -- which insured mortgage-linked investments -- to fend for themselves. These "bad banks" could be downgraded and even go into "run off" mode, waiting for existing policies to expire and paying claims, but not selling new insurance. These units could try to raise capital, or banks that own the debt securities insured by these units could cancel their policies and get cash or stakes in the "good bank."

Q: What is Mr. Ackman's plan?

A: The structured-finance business connected to struggling mortgage investments would own 100% of the low-risk municipal-bond insurance business, which would retain its triple-A rating. The municipal unit would have its own board and pay dividends to its parent, which, if anything is left after paying its claims, would pay dividends to the holding company.

Q: Is this good for shareholders?

A: Very few options are good for shareholders right now, this included. If mortgage losses are significant, investors in the holding companies and the firms' creditors would likely see their investments become nearly worthless under Mr. Ackman's plan.

Q: What impact would all this have on holders of bonds insured by the firms?

A: In a good bank/bad bank plan, municipal bondholders would be fine because their bonds would be backed by a triple-A insurer. The holders of other securities, including less-risky consumer debt, could see the value of their investments drop because they would likely be insured by weaker firms that might be unable to pay claims. Banks, which hold billions of dollars of these securities, might sue for "fraudulent conveyance," in which an entity uses a pool of assets to pay one obligation and not another.

Q: How will this all play out?

A: In the end, it depends on two factors -- the severity of losses on mortgage-related bonds, for which the outlook has deteriorated, and how easily the bond insurers can raise new capital, which has become tougher as their share prices have plummeted.


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