The Wall Street Journal-20080216-Bond Insurer Seeks to Split Itself- Roiling Some Banks

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Bond Insurer Seeks to Split Itself, Roiling Some Banks

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The beginning of a messy endgame to the bond-insurance crisis may be underway, and the industry that emerges could look very different from the one that bet big on subprime mortgages.

On Friday, FGIC Corp., holding company for the nation's third- largest bond insurer, told the New York State Insurance Department that in effect it wants to split up the business. The idea would be to create a new company to insure safe municipal bonds and for the existing one to keep responsibility for riskier debt securities already insured, such as those tied to the housing market.

The move may help regulators protect investors who have municipal bonds insured by the firm. But it could also force banks who are large holders of the other securities to take significant losses. Some banks that have been talking with FGIC in recent weeks to bolster the firm were taken aback by the announcement and could yet try to block it, say Wall Street executives.

Either way, the move is a further sign that the industry could retreat from insuring some of the complex financial instruments that fueled the recent housing boom.

If the market settles down, that would be good news for local governments that have been dragged into the subprime-mortgage mess. They would like to see competition among financially solid bond insurers, so that the cost of insuring their municipal bonds remains low.

"Certain aspects of the business model almost certainly will not look the same at the end of the year," said New York State Insurance Superintendent Eric Dinallo, who has been consulting with the bond insurers about new regulations that will cover what risks they can assume.

Already, MBIA Inc., the largest bond insurer in the country, has been forced to raise more than $2.5 billion in capital in an attempt to preserve its triple-A credit rating. Ambac Financial Group Inc., the second-largest, has also been talking with banks about a possible rescue plan.

Additional pressure came from New York Gov. Eliot Spitzer, who told Congress on Thursday that bond insurers have three to five days to find a solution to their problems before regulators could step in. Lawyers for insurers and banks are expected to work through the U.S. holiday weekend.

Bond insurers have been around for decades, but little noticed by the public. They built their business by promising to repay interest and principal on bonds issued by municipalities if the municipalities defaulted. The insurance made the borrowing cheaper. Now, the insurers have become a linchpin of the financial system, backing more than $2 trillion worth of securities.

The industry plunged deeper into riskier business lines in recent years, including insurance for securities backed by subprime mortgages. The downturn in the mortgage market has exposed them to potentially sizeable losses. That has, in turn, called into question whether they can maintain the triple-A ratings that are critical to their business, and has forced some to go looking for more money.

Holders of the debt securities -- ranging from banks to ordinary investors -- also have a lot at stake because the value of the securities hinges in part on the rating of the insurer. That's one reason regulators have been trying to rally banks to help rescue the insurers.

FGIC has already lost its top-notch triple-A rating from all three major ratings firms. Moody's Investors Service on Thursday cut FGIC's triple-A financial-strength rating by six notches to A3, with a warning that it could be cut to the lowest investment-grade level of Baa if FGIC's strategic and capital plans had "an unfavorable outcome."

Mr. Dinallo told Congress on Thursday that the department would consider letting bond insurers split themselves in two, effectively giving his imprimatur to the idea.

On Friday morning, FGIC's general counsel, Ed Turi, notified Mr. Dinallo's department of its intent "to begin the process" of creating a new bond insurance company in New York. That would require the department to issue a license. If it gets a license, the new insurer will support public bonds previously insured by FGIC and seek new municipal-bond business, the company said.

Mortgage insurer PMI Group Inc. owns a 42% stake in New York-based FGIC, while private-equity firms Blackstone Group Inc. and Cypress Group each hold 23%. FGIC insured about $315 billion in debt as of Sept. 30, including about $31 billion backed by mortgages.

FGIC's move caught at least some of the banks in the group that have been negotiating with it by surprise, according to a person familiar with the situation. Banks that own securities insured by FGIC face the risk of write-downs if FGIC is downgraded further, because the value of securities it insures could fall further.

FGIC's move could serve as an incentive to get the banks to step up to the plate on a cash infusion for the company. In the past, regulators have said dividing the insurers is a last resort and urged the banks to put in fresh capital.

Calyon, the investment-bank arm of Credit Argicole SA, is leading the bank group. A Calyon spokeswoman declined to comment.

The full bank group has had only tentative discussions with FGIC. One question that has dogged the group is whether the principal negotiating partner should be FGIC, its shareholders or regulators.

The banks learned of the split-up plan Friday by seeing it reported on CNBC, this person said, calling it a "bizarre situation."

All of the banks have hired legal counsel and are prepared to go to court. The person familiar with the situation said FGIC's move could result in "instant litigation." FGIC didn't respond to queries about the banks' reaction to Friday's announcement.

One plan the parties are discussing involves commuting, or effectively tearing up, the insurance contracts the banks entered into with FGIC, according to another person familiar with the matter. In exchange, FGIC would pay the banks some amount to offset the drop in value of those securities, or give them equity stakes in the new municipal-bond insurance company.

Some observers questioned whether the breakup plan would be fair to all FGIC policy holders. It would probably help municipal governments, because the entity insuring their debt would be healthier, while hurting those who mainly relied on FGIC to insure riskier securities. Also unclear is how the ratings services would treat the two insurers after a split.

"You're trying to unscramble the egg," said William Schwitter, chairman of the leveraged-finance practice at law firm Paul Hastings. "When you take a balance sheet that is supporting a variety of obligations and try to split it in two, it's difficult."

Mr. Schwitter, who isn't involved in the FGIC negotiations, noted that many investors who bought bonds supported by FGIC insurance probably had no idea the company could be split later.

However, if a breakup is endorsed by the New York Department of insurance, that could limit the legal liability.

One other wild card: If FGIC splits into two, it could throw into turmoil potentially billions of dollars of bets that banks, hedge funds and other investors have made on whether FGIC would default on its own debt. If FGIC is split, it isn't clear how those "credit default swaps" would be valued, since one half of the new company would have a higher risk of default than the other.

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Aaron Lucchetti contributed to this article.