Hard Choices Ahead for Regulators in Bond Insurance Solution

As major bond insurers begin to examine the possibility of splitting their books of business, separating the relatively safe municipal bond obligations from the more troubled structured portfolios exposed to the U.S. mortgage markets, regulators looking to protect diverse policyholder interests are going to have difficult choices ahead, according to Fran Semaya, head of the insurance corporate and regulatory practice at Cozen O'Connor. 
 
Proposed by New York Insurance Superintendent Eric Dinallo during Feb. 14 testimony before the House Financial Services Subcommittee on Capital Markets and Insurance, the so-called "good bank/bad bank" approach looks to ensure that more than $1.6 trillion in insured outstanding municipal obligations are not threatened by downgrades to the bond insurers themselves. But for major commercial banks that already have had to take significant write-downs on their holdings of collateralized debt obligations, such a split is a far less desirable outcome. 
 
At least one of the major firms -- privately held Financial Guaranty Insurance Co., which is 42% owned by mortgage insurer PMI Group Inc. -- has expressed interest in the plan, telling Dinallo's office that it would like to be split into two companies. 
 
Under such a plan, Semaya said in an interview with BestWire, a new company would be formed to retain the municipal bond and other relatively healthy risks, and would made a subsidiary of a new corporation that would retain many of the more distressed structured product offerings, including credit default swaps. 
 
"The regulators would have to worry about the solvency of the two entities. The second thing, and the most important for the rating of the bonds, is to maintain a AAA rating," Semaya said. 
 
Financial guaranty insurers cover losses from specified financial transactions, guaranteeing investors in debt instruments timely principal and interest payments in the event a default occurs. Historically focused on insured bonded municipal debt, several of the sector's major writers have been stung in recent months by write-downs of their exposure to CDOs and asset-backed securities. 
 
Rep. Paul Kanjorski, D-Pa., chairman of the capital markets subcommittee, has expressed support for extending a federal line of credit, possibly as large as $10 billion, to ensure that muni obligations are not downgraded, which some experts fear would spark forced selling by money market mutual funds and other institutional entities that are required to hold highly rated investments (BestWire, Feb. 14, 2008). The full Financial Services Committee is set to examine the sector in a March 5 hearing. 
 
Dinallo himself has taken the lead in negotiating talks among major commercial banks exposed to potential bond insurer downgrades, but conceded during his congressional testimony the difficulty of working out the details of such an arrangement. Each of the monoline insurers ultimately could pursue differing courses depending on the circumstances particular to that company, the superintendent said. 
 
"Some could have a split book, some could have a consortium-backed capital infusion, some could have a good book/bad book outcome, but in all of those, you're dealing with what is clearly a distressed situation," Dinallo said. 
 
Should the situation become so dire that the Insurance Department moves to take control of one of the companies, regulators would decide whether to place the company into rehabilitation or liquidation, Semaya said. 
 
"In a rehabilitation, the regulator, by court order...would attempt to take the company and be able to come up with a plan of rehabilitation, to have the company saved and put back out in the market; the idea is to protect the assets of the company, so that the assets do not dissipate as they're trying to d