February 19 2008: 3:07 PM EST
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Troubled bond insurer braces for change

A CEO shakeup shows MBIA is ready to put its house back in order. Now comes the hard part

By Colin Barr, senior writer

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NEW YORK (Fortune) -- MBIA on Tuesday became the second bond insurer to replace its chief executive this year, bringing former chief Jay Brown back to replace Gary Dunton. Ambac, the second-largest financial guarantor after MBIA, last month named Michael Callen to take over for the retiring Robert Genader.

But the executive suite shakeups are just the beginning for these companies, which are trying to avoid damaging downgrades of their triple-A ratings. Reports indicate that Ambac (ABK) and MBIA (MBI) are considering joining their smaller rival FGIC in splitting their low-risk muni-bond operations from their riskier structured finance businesses - which insure mortgage-related securities whose value has been hit by the credit crunch and the housing crisis. By splitting the muni businesses from their structured operations, the companies hope to steer clear of a downgrade that could force some bondholders to sell and drive up funding costs for issuers.

No formal split plans have been announced, but the companies and regulators are eager to avoid a downgrade. Wall Street analysts say banks and brokerages that hold insured mortgage-related securities could end up with billions of dollars in new writedowns. Making the concept work may also be sticky: Some observers warn of a wave of lawsuits by policyholders and investors who bought asset-backed securities guaranteed by the bond insurers.

But Christopher Whalen, managing director at risk manager Institutional Risk Analytics, says separating the lucrative muni bond operations from the mortgage-related lines makes sense for players like MBIA. He believes the separation could be achieved in relatively painless fashion through a spinoff to shareholders.

What's more, Whalen argues that MBIA and Ambac are much healthier than many investors think. He says that worries about the bond insurers' financial health are based on what he calls the "utopian concept" of fair value accounting, which overlooks what's really important: the cash profits and losses incurred by a business. By those measures, he notes, MBIA and Ambac are stable.

"This is madness," Whalen says of the regulations that forced MBIA to recognize a $3.5 billion mark-to-market loss on its credit derivatives portfolio, in a period in which the company's credit-impairment reserves were only $200 million. "We've twisted our thinking so that up looks like down."

A game nobody wants to win

For now, the split talk will only add to the uncertainty surrounding Ambac and MBIA. The companies have seen their shares lose more than 80 percent of their value over the past year amid worries about their exposure to possible losses on mortgage securities. Regulators, hoping to contain any broader financial-sector problems, have been considering ways to shore up the bond insurers - possibly through infusions of new capital from the banks that do business with the insurers.

"The best way to protect all the policyholders is to preserve the triple-A ratings of some of the bond insurers," New York state insurance superintendent Eric Dinallo said in congressional testimony last week. "So we have been attempting to facilitate additions to the capital strength of the bond insurers, not for their own sake, but to protect first policyholders and second the markets and broader economy."

But FGIC, a smaller bond insurer partly owned by mortgage insurer PMI Group (PMI) and private equity firm Blackstone (BX), filed last week to split its muni-bond operations from its structured finance business. FGIC made the move after Moody's downgraded its ratings, and after talks with its banks apparently failed to produce the desired results. Now Ambac and MBIA - neither of which has yet been downgraded by Moody's or S&P - are said to be considering a possible breakup as well.

The question now is how any restructuring might protect the interests of municipal policyholders vis a vis those of structured finance policyholders, and how much capital the insurers may need to raise. MBIA has raised $2.5 billion this year through common and preferred stock sales, while Ambac canceled a $1 billion capital-raising plan last month.

Don Brownstein, chief investment officer at Structured Portfolio Management in Stamford, Conn., describes the process of deciding who will pay for potential losses tied to toxic mortgage-backed paper as "a game of musical chairs in which no one actually wants to get the seat."

Brownstein, whose fund reportedly returned 185 percent last year because of winning bets against subprime-related securities, says regulators are obliged to step in and find a solution funded by Wall Street, because otherwise taxpayers will end up on the hook for the profit-seeking mistakes of Ambac and MBIA, among others. Indeed, the recent freeze-up in the auction-rate securities market - in which high-grade bond issuers such as the Port Authority of New York and New Jersey ended up briefly paying interest rates as high as 20 percent - shows the potential for costly turmoil in the municipal bond markets.

But Janet Tavakoli, who runs Tavakoli Structured Finance in Chicago and has written about collateralized debt obligations, warns that even a successful effort to recapitalize Ambac and MBIA may not quiet skeptics of the bond insurers. She calls some of the structured finance deals they insured "opaque" and "convoluted," making them difficult for investors to assess.

"The questions start with the appropriateness of the underwriting" that Ambac and MBIA did in structured finance," she says. "You can't just write a check and fix that."  To top of page