FGIC's bold bet
The nation's third-largest bond insurer hopes to save itself by splitting in two. Not all investors like the plan.
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NEW YORK (Fortune) -- Problems in the bond market mounted Friday when Financial Guaranty Insurance Company, the nation's third-largest bond insurer, stunned investors with a proposal to split up in a last ditch bid to salvage its municipal bond ratings. The move came one day after Moody's sharply cut the company's insurance unit ratings and lowered its corporate debt to below investment grade.
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's move was born out of desperation. Like rivals MBIA (MBI) and Ambac (ABK), FGIC branched in recent years beyond its core business of insuring municipal bonds and into complex investments backed by mortgages. But the severe housing slump and the credit crisis it triggered has created big problems for bond insurers, which may not be able to pay claims as default rates soar. Of all the bond insurers, privately-owned FGIC is seen as the most likely to fail.
A breakup may just be FGIC's best option given the brutal choices all bond insurers face as politicians and regulators clamor for protection for - and interest rate savings from - debt issued by cities and towns. With FGIC's structured product portfolio rapidly deteriorating, time is running short.
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.
A company split is far from a done deal, as New York state regulators, who must approve the plan, noted on Friday. But if it happens, it would spell the end of FGIC's structured product group. That's because a split would put the company into what's known in the insurance industry as a "run-off," which would essentially prevent it from seeking or writing new business. The structured product unit would also lose access to the cash flow from the muni division's premiums.
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.
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.
An FGIC spokesman declined to answer questions Friday. In a prepared statement, the company said it had considered "various capital-raising and other initiatives" in recent months before settling on a proposed split. "Once licensed, [the new muni bond insurer] would be used to provide support for public finance obligations previously insured by FGIC and to write new business to serve municipal markets," it stated.
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.
A quick look at FGIC's portfolio of insured portfolio of CDOs and other mortgage-backed securities clear just how stark the choices are for the insurer.
As of Sept. 30, FGIC had $31.3 billion in mortgage-backed security insurance in place, 25 percent of which covered subprime pools and 54 percent guaranteed bonds backed by home-equity loans. The secondary markets for these securities have virtually collapsed over the past several months. About 55 percent of FGIC's mortgage book, or more than $17.1 billion, was rated triple-B, just above investment grade.
While market prices don't necessarily say anything about an insurer's ability to pay, these investments have all seen default rates skyrocket in the bonds underlying collateral, which would eventually force FGIC to make payments, presumably for many years to come.
One risk analyst, Christopher Whalen of Institutional Risk Analytics, says FGIC has little choice but to break up - or else risk being shut down by regulators. Without a significant infusion of cash, the company's structured product unit, he said, would be unable to cover losses.
"[New York State Insurance Department Superintendent] Eric Dinallo would have been advised to go after their charter to do business in the state," said Whalen. 
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