Ambac Decides Against Splitting: Litigation Risk Forces a Market-based Solution

This from today's Financial Times:

Ambac, the troubled bond insurer, has decided against splitting in two as it completes a $2bn-$3bn recapitalisation, insiders said.

Under a recent proposal, Ambac, the second biggest bond insurer, or monoline, would have split its operations into a triple-A-rated municipal bond insurance business and a structured finance business with potentially lower ratings. A lower rating on the structured part of its business could have forced banks to reduce the value of guarantees on collateralised debt obligations and on derivative trades.

There was also the possibility of lawsuits by banks and other groups that bought insurance on CDOs and other structured products.

********************

Although Ambac’s past guarantees are expected to remain together, its future business is likely to be different. Ambac announced late last week that it had slashed dividends and would stop providing insurance on structured finance deals for at least six months.

The moves, similar to those announced by MBIA, the biggest bond insurer, which has been grappling with a lack of investor confidence in its financial strength, are designed to preserve capital. Ambac said halting its structured business for six months would free up $600m in additional capital, for example.

Remember when New York State Insurance Superintendent Eric Dinallo was saying "Split, or else" to the monolines, and yours truly said that this seemed a bit far-fetched due to the overwhelming complexity and litigation risk associated with such a maneuver?

All this talk of a government-driven break-up of bond insurers into their municipal and non-municipal (read: structured mortgage securities) components leaves me scratching my head. Why are so few calling bullsh*t on New York State insurance superintendent Mr. Dinallo and his strong-armed tactics? This is not the government urging a solution, this is more akin to the government holding a gun to the head of bond insurers and saying "Restructure - or else..." And it is just not that simple due to the complex webs of financing arrangements among the bond insurers, the banks and the buyers and sellers of credit protection on both the firms themselves and the securities they've backed. His actions may well have unintended consequences that far exceed any benefits that might be created, largely by calming down issuers of and investors in municipal debt obligations.

********************

But I can see the government-driven bond insurance restructuring program getting mired in a protracted court battle among entrenched interests on all sides. But instead of simply reporting on the bond insurance industry break-up I'd like to see some more critical analysis of its cost and benefits. Because taking this step is a big deal and sets a very worrisome precedent. There is urging and facilitation and then there is coercion, and Mr. Dinallo's steps are falling dangerously close to the latter.

The solution being pursued by Ambac is the right solution, IMHO. Rebuild capital. Enforce a delayed run-off of the structured finance side of the business while keeping the municipal bond insurance "crown jewels" intact. Proactively work for the interests of all shareholders, not merely to placate a Governmental agency. And much like the outcome of the "Super SIV" machinations, the market arrived at a better solution while Government suasion (or in this case, outright threats) served as a catalyst for action. So while I threw a few stones at Superintendent Dinallo, at the end of the day his bare-knuckle tactics got results. Long live market-based solutions.