Ambac: Split Us In Two / What Does It Mean?

A: Ambac is considering following in FGIC's footsteps to split itself up, effectively trying to distance itself from the toxic portion of their business. Ambac is the #2 biggest bond insurer. This would leave MBIA as the biggest and last company to reveal their plans to stave off credit downgrades. So, what does this mean? In short, it protects the muni book and potential ramifications to the muni market should a downgrade come. It does NOT solve the problem of financial losses due to the toxic insurance sold to banks, brokerages, & other institutions for their structured credit investments that went sour. A new wave of write-downs should be expected.

The news via WSJ.com:Ambac

Financial Group Inc. is in discussions to effectively split itself up in a move aimed at ensuring that municipal bonds backed by Ambac retain high credit ratings, according to a person familiar with the situation.

This is an organizational thing that will speed up the credit cycle so that we go through the pain faster in order to see the light at the end of the tunnel sooner. Will it work? Well, it all depends on how deep the credit crunch really goes, whether housing stabilizes or continues to fall, how affected the consumer is and the lagging effect on the economy, and how effective stimulus will be as time goes on. Lots of unknowns.

Ambac is considering splitting itself into two entities: MUNI PORTION + STRUCTURED CREDIT PORTION. Needless to say, the muni book is a safe & profitable business that would have been an innocent victim if the combined company was downgraded by the ratings agency. This was a very big threat to wall street and one that we discussed here on UrbanDigs months ago. It's also one reason why Buffet vultured in and offered to buy the muni book from the insurers and re-insure about $800 Billion in muni bonds; because its a safe & profitable business.

Which brings us to the structured credit portion of Ambac's book; the chicken shit. This is the toxic portion of the bond insurer's balance sheet and is so complex that nobody really can quantify the potential liability associated with the insurance it wrote for investors of these products. All we know is that its a complete mess and a ticking time bomb. This is the root cause of ratings downgrades threats.

By separating the business into two entities, Ambac would distance it's good business from the bad. Any future lawsuits, future ratings downgrades, or future liabilities associated with the bad business would be unable to tap into the good business; as far as I understand this scenario (feel free to correct me with any details if you understand this better than I). Now that the muni business is protected, the new entity holding the toxic waste will be downgraded and likely enter into bankruptcy protection. So, with the split here is what will likely occur:

AMBAC SPLIT ---> NEW BAD ENTITY GETS DOWNGRADED ---> NEW BAD BUSINESS ENTERS BANKRUPTCY PROTECTION ---> MORE LOSSES FOR HOLDERS OF THESE INVESTMENTS AS INSURANCE IS WORTHLESS

Which brings us to the ultimate point of this post. If the new split up company that insured the structured credit investments gets downgraded and goes into bankruptcy protection, it will leave those who bought the insurance as protection against losses holding the bag. It means a new wave of write-downs for banks, brokerages, hedge funds, and any other institutions that insured their CDO's & other products with Ambac. Future government intervention either for the new bad entity or for banks.

Professor Nouriel Roubini touches on the potential fallout to the institutions that are left holding the bad with worthless insurance:

"...a massive writedown – about $150 billion – of the mortgage related securities (RMBS, CDOs, etc.) that had been “insured” by the monolines."

As I wrote many times in the past few months, this is a credit tsunami with many waves as it spreads to areas that once were considered safe; i.e. student loans, auction rate securities, etc..

I must say that it is a very good thing if the muni markets do not directly get penalized for the bad bets made in the structured credit markets. If there was no solution to protect the muni book and these insurers got downgraded across the board, you will see a shockwave of instability and uncertainty hit the US & Global markets. Eliminating this fallout is a good thing. However, even with this solution, confidence may be rocked a bit in the muni markets if this credit crunch continues. So, while it is not a saving grace, the solution to split the insurance companies into two should expedite the credit cycle process leading to the inevitable: more losses, more regulation, tighter lending standards, and the continuing process of cleaning the mess that was made after years of lax lending & bad bets on securities derived from the unsustainable housing boom.

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