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Bond Insurers' Bait and Switch

Picture this: You walk into a casino, head straight to the blackjack tables, and plop down money on two different hands. One hand scores a perfect 21; the other busts and is worth nothing.

You politely inform the pit boss that you would like to keep only the good hand, and dump the bad hand on others who will inherit the loss and deal with the headache.

Only in your dreams, right? In Las Vegas, yes. For bond insurers, it's reality.

Headed for splitsville
After months of battering, bond insurers Ambac (NYSE: ABK  ) and privately held FGIC are both throwing around the possibility of breaking themselves apart, separating their still-stable municipal divisions from their roiled CDO departments. For FGIC, the move came just one day after the insurer sustained another credit downgrade, this time from Moody's (NYSE: MCO  ) .

"So what?" you say. Companies break themselves apart all the time. Altria Group (NYSE: MO  ) plans to spin off its Philip Morris International division, freeing it from the regulatory burden of domestic brother Philip Morris. McDonald's (NYSE: MCD  ) spun off Chipotle (NYSE: CMG  ) to release the burrito joint from the Golden Arches' shackles. How is a breakup of bond insurers any different?

If bond insurers separate the municipal side from the CDO side, it would be more appropriate to call the move a "writeoff" rather than a "spinoff." Last week's offer from Warren Buffett to take the municipal business off bond insurers' hands was basically laughed off, because everyone knows that the CDO division by itself isn't worth its weight in jelly beans.

Bond insurers are already suffering credit downgrades, even with the strength of the municipal bond business. Strip that away, and the fate of the CDO division is essentially written in stone.

What would that mean? A separate company, holding nothing but CDO insurance, would undoubtedly merit a paltry credit rating at best. That would spark even more downgrades of CDOs, which are already feeling the wrath of the softening real estate market, and could eventually lead to further writeoffs from banks like Citigroup (NYSE: C  ) and Merrill Lynch (NYSE: MER  ) .

Let's not play favorites here
If you held an insured CDO, and a bond insurer broke off the only part of its business keeping its head above water, you probably wouldn't be too happy. By splitting up, insurers are essentially salvaging municipal clients at the cost of the CDO clients, who could be left high and dry.

If those who paid for CDO insurance had known they'd be dealing with a company stripped of its main line of business, would they have been willing to pay the same insurance premium? Sign up with one company, end up with another? That's why I consider it "bait-'n-switch."

United we stand, divided we fall ... hard
Talk of splitting up divisions brings up an important point: Who really needs insurance? A stand-alone municipal insurance division would probably be granted a triple-A credit crating, simply because the history of default in this market is slim to none.

That said, if there's any hope for salvaging the insurers in their current form, it'll likely depend on using the steady cash flows from municipals to back up the ever-growing claims on CDOs. Insurers need capital more than anything, and I doubt anyone would be willing to risk enough money to save a CDO insurer without the stability of the municipal business there for protection.

It's still a long shot, but perhaps the only scenario in which both divisions come out alive involves keeping the insurers as they are, with both municipal and CDO divisions under one roof, and hoping that someone like Wilbur Ross or a sovereign wealth fund comes to the rescue.

Until then, check out this related Foolishness:

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