by Calculated Risk on 2/15/2008 08:34:00 PM

From the WSJ: Bond Insurer Seeks to Split Itself, Roiling Some Banks

The beginning of a messy endgame to the bond-insurance crisis may be under way, and the industry that emerges could look very different from the one that bet big on subprime mortgages.

On Friday, Financial Guaranty Insurance Co., the nation's third-largest bond insurer, told the New York State Insurance Department that it will ask to be split into two separate companies. The idea would be for the new company to insure safe municipal bonds and for the existing one to keep responsibility for riskier debt securities already insured, such as those tied to the housing market.

The move may help regulators protect investors who have municipal bonds insured by the firm. But it could also force banks who are large holders of the other securities to take significant losses.
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All of the banks have hired legal counsel and are prepared to go to court. The person familiar with the situation said FGIC's move could result in "instant litigation."
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One plan the parties are discussing involves commuting, or effectively tearing up, the insurance contracts the banks entered into with FGIC ... In exchange, FGIC would pay the banks some amount to offset the drop in value of those securities, or give them equity stakes in the new municipal-bond insurance company.
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"You're trying to unscramble the egg," said William Schwitter, chairman of the leveraged-finance practice at law firm Paul Hastings. "When you take a balance sheet that is supporting a variety of obligations and try to split it in two, it's difficult."
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However, if a breakup is endorsed by the New York Department of insurance, that could limit the legal liability.

This really is unscrambling the egg. If the company is split in two, the muni bond insurer will probably be fine, and there is a strong possibility that the risky insurer would file bankruptcy. This would never work without some sort of agreement to limit the liability of the muni bond insurer. If the goal is to get the muni market functioning again - as it appears is the main goal of the NY Dept. of Insurance - then this makes sense. In that case, the banks will be revisiting the confessional soon.