MBIA (NYSE: MBI) became the latest bond insurer to announce plans to split its still-healthy municipal bond insurance division from the rest of its portfolio, which insures notoriously toxic CDOs backed by subprime mortgages.
Last week, rivals Ambac (NYSE: ABK) and FGIC announced similar plans to essentially divide themselves into a "good company" and "bad company." Whatever happened to "Until death do us part"?
But you seemed like such a happy couple!
What's prompting these companies to split their businesses in two? The real threat isn't an actual risk of default by bond insurers; it comes instead from looming credit downgrades by Moody's (NYSE: MCO) and McGraw-Hill's (NYSE: MHP) Standard & Poor's. Any credit downgrade by a major rating agency is a one-way ticket to the cemetery at this point.
That puts bond insurers in quite a sticky position. Management of both Ambac and MBIA have insisted all along their pockets remain deep enough to cover losses. Last month, MBIA CFO Chuck Chaplin pointedly reminded investors, "There is not an event on the horizon that anyone can foresee that would result in MBIA or its insurance units becoming insolvent."
That's probably true, but it doesn't guarantee that the insurers will make it out alive.
Combined, the municipal and CDO divisions likely do give insurers enough cash on hand to cover claims. Even the most pessimistic investor, Bill Ackman, estimates that claims will be around $11 billion. Yet MBIA has more than $17 billion in total claims-paying ability. So why all the fuss?
Having enough cash to pay claims doesn't necessarily constitute triple-A status. To be granted such, insurers must have so much ammo that when utter disaster arrives, the companies can play claims for four years, yet still maintain a 25% cushion. Without splitting up the two divisions, there's just no way the insurers can do that.
No prenup here
So breaking apart the two divisions now seems to be the choice du jour. By getting rid of the ugly CDO division, a stand-alone municipal division has a good shot at keeping triple-A status. If at first you don't succeed, rip yourself apart and hope for the best? Sounds good to me.
But as I pointed out last week, the divide-and-survive strategy sports serious ailments of its own. Splitting up the two divisions means certain death for CDO insurance, and I'll guarantee that banks like Washington Mutual (NYSE: WM) and Citigroup (NYSE: C) will go out kicking and screaming (read: serious lawsuits) before they allow that to happen.
Now we see the serious predicament insurers face: Keep both divisions under one roof, and essentially sign their own death certificates, or split apart and cause another wave of huge writedowns from CDO holders already under the gun.
The huge market for municipal insurance throws another spanner in the works. Berkshire Hathaway offered earlier in the month to take municipal insurance off the hands of Ambac, MBIA, and FGIC. If the insurers stay in their current form -- hence losing triple-A status, and likely going out of business - Berkshire would buy the municipal policies in two seconds flat. If the insurers split apart, they'll be able to keep municipal insurance going by themselves. CDO insurance is probably toast either way, while municipal insurance policies will be just fine either way. That's the terrible irony of all of this; the only way out is to save municipal insurance, which doesn't need to be saved in the first place.
What now?
It's nearly impossible to think of a scenario that benefits shareholders at this point. Splitting up would create a near-worthless CDO insurance company and a municipal insurance outfit competing directly with Berkshire. A bailout would likely wipe out what little equity shareholders currently hold. There just aren't any attractive options out there. That's why Bill Ackman is smitten.
In the end, just like any other situation in life, the mistakes must be paid for in full by those who took on the risk. For the bond insurers, the "heads you lose, tails you lose" options left on the table have all but eliminated hope for a rosy future, making theirs a painful predicament indeed.
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