A Good Company and Bad Company Split Isn’t a Complete Solution for the Bond Insurance Problem
The bond insurance companies need to raise capital to maintain their AAA ratings. So far, attempts to raise additional capital have not been successful. If the bond insurance companies lose their AAA ratings, they will be forced out of the municipal bond insurance market. Other problems are also expected. This is a very complex situation involving different groups with competing interests. If anyone is looking for additional background on this matter, there have been many excellent articles on the Minyanville.com website and I encourage anyone who reads this to check that site for additional discussion of this topic. Look for articles written by Mike Shedlock or Kevin Depew.
The current market perception is that a bond insurance company will split into two insurance companies: a “GoodCo” and a “BadCo”. Think of BadCo as the original insurance company after all of its salvageable parts are removed and put into the GoodCo.
Divisions of existing insurance companies have happened before. There are many steps necessary to get this accomplished and ultimately it must be approved by an insurance regulator. It is possible that all of the bond insurance companies may seek to split into GoodCo’s and BadCo’s.
Why would an insurance regulator approve such a split? Usually it is to protect the best interests of the policyholders or claimants depending on the nature of the insurance at issue. In this situation, there are many competing interests and some parties are going to be disappointed if not outright hurt.
Typically, the BadCo retains all of the existing business, existing assets and existing liabilities and is left on its own to either succeed or fail. The shareholders of the original insurance company and more importantly their contributed capital also tends to stay with the BadCo. It is very difficult to move capital out of BadCo as the regulators act to protect the policyholders and claimants, not the shareholders. In the case of the bond insurance companies, the division of business might be done along the lines of all municipal bond business both past and present will be put into GoodCo while all non-municipal bond business would be left in BadCo. Most anything is possible depending on the objective. The publicly stated objective seems to focus on helping the municipal bond community.
Given this objective, my guess is that GoodCo would get the unearned premium reserves and loss reserves for the municipal bond business along with some very liquid assets that are basically cash or cash equivalents. Unearned premium reserves are prepaid premiums for insurance that has not run its course. Loss reserves are the existing liabilities for both known and unknown losses. Accountants and actuaries will decide these amounts. The end result is a very “clean” company with bright prospects that will need capital.
Everything else would be left behind in BadCo. This would include all of the existing liabilities for the non-municipal bond portfolio, all of the new and renewal business of the non-municipal bond insurance portfolio and all of the hard-to-value assets. Nearly all of the capital of the original shareholders would also stay in BadCo. It is very unlikely that the insurance regulators would allow any of the shareholders’ capital to be moved to GoodCo. The premise is that if there was sufficient capital in the original company for both companies, there would be no need to split. The end result is a very “dirty” company with uncertain prospects that will need capital.
There is a paradox in play here. Think about the companies as if they were still together. GoodCo does not need BadCo. BadCo desperately needs GoodCo. On a go-forward basis, most of the profitable business has been moved to GoodCo. BadCo will need these profits to fund its losses. Without these profits BadCo will need more capital. (Even with GoodCo, BadCo might still need more capital). At the same time, GoodCo would not likely exist if it was still associated with BadCo. On a combined basis, GoodCo and BadCo cannot access the capital they need to maintain their “good” book of business.
There is an expectation that the policyholders and maybe even the shareholders who remain with BadCo will file lawsuits. They may. If BadCo is not afforded a AAA rating, it seems almost certain that there will be lawsuits. What happens depends on the final solution for BadCo as BadCo is the essence of the problem here. The regulators will fall back on a position that the market place has effectively taken away the municipal bond business from BadCo. There is some suggestion of this in the reinsurance transaction proposed by Warren Buffett which would have effectively separated the municipal bond business from the existing insurance company. (No reinsurance coverage was offered for the non-municipal bond book of business. No existing insurance companies have accepted the reinsurance proposal). The regulators will fall back on a position that BadCo has not been harmed by a reduction of capital as effectively no material amounts of capital will be transferred from BadCo to GoodCo. Whether the lawsuits have any merit will be determined by judges and juries.
Splitting up an existing bond insurance company does not help to save the AAA rating of either the BadCo or the GoodCo. What it does accomplish is that BadCo and GoodCo can move forward separately and take the necessary steps to maintain or receive a AAA rating. How is this done? Think large infusions of capital. There are other requirements but this is the primary issue at hand. Who will contribute this capital? It is not clear. Remember, there are now two separate companies with very different prospects.
Looking at GoodCo it is fairly straight forward. If they are lucky, a safe guess would be that the existing shareholders of the original insurance company will get a chance to reach into their own pockets and capitalize GoodCo with new money. Think of it as a rights offering. To the extent that they can contribute sufficient additional capital to obtain a AAA rating everything would be all set. To the extent that they fail or do not even get the chance to capitalize NewCo, NewCo would have to go to the marketplace to raise the necessary capital. Given that NewCo is effectively getting a fresh start and that writing municipal bond insurance has historically been a profitable venture, finding investors will not likely be a problem.
Why is GoodCo important? With GoodCo in place, the potential disaster of a variety of stakeholders being forced to sell municipal bonds in a panic if they lose their credit enhancement insurance is avoided. Also, GoodCo would allow municipalities to secure credit enhancement insurance for any ongoing issuance of debt. This is usually cost beneficial to the issuing municipalities. GoodCo is the not the gigantic pink elephant in the room that everyone is ignoring.
Raising capital for BadCo is a different situation. This is where you find the gigantic pink elephant. Think of BadCo as being in the business of insuring the financial market’s equivalent of Pandora’s Box. How much capital BadCo would need is up for debate. It is likely a substantial amount of capital that cannot be provided by any typical investor. Collectively, the bond insurance companies insured a notional value in the trillions of dollars range. These policies were written at a time when it was a far-fetched idea that losses were even possible let alone likely.
The most overlooked perception of the BadCo and GoodCo split is that BadCo also needs to have a AAA rating. A financial marketplace where BadCo does not have a AAA rating is almost unimaginable. BadCo will continue to insure a variety of financial instruments that are held by banks, hedge funds, private equity firms, pension funds, mutual funds and private investors. This all circles back to “mark to model” or “mark to make believe” accounting. Most, if not many, if not all, of those financial instruments require a AAA rating to allow “mark to make believe” accounting. How will those instruments retain their AAA ratings if they are not insured by a AAA insurer? They won’t. There are also issues with reserve requirements for banks. Financial instruments with AAA ratings have much lower reserve requirements than financial instruments with lower ratings. There are also issues with various groups that might be forced to sell certain financial instruments that have lost their AAA rating.
It is not clear as to how this will all play out. A GoodCo and BadCo split is a start to a solution and a split seems inevitable. The split is not the final solution but merely a step along the way. What gets overlooked is that BadCo will still be writing insurance and BadCo will need a AAA rating for the status quo to remain in place. It is unlikely that there will be a market solution to affording a AAA rating to BadCo or the many BadCo’s that may exist in the future. If BadCo does not have a AAA rating after the split from GoodCo, expect lawsuits.
