Bond insurance splits could fuel CDS rally: report

NEW YORK (Reuters) - Credit default swaps on bond insurers could rally significantly if plans are completed to separate their municipal debt insurance arms from their troubled structured finance divisions, Bank of America said.

FGIC Corp, which has lost its "AAA" rating from all three major rating agencies, plans to move its municipal bond insurance business into a new company and leave its structured finance guarantee business in the existing company, a New York Insurance Department spokesman said on Friday.

New York State Insurance Superintendent Eric Dinallo said on Thursday it was within the state's power to force bond insurers to restructure to separate their municipal bond business from riskier operations, which include exposures to risky mortgage-backed securities.

"Should such a proposal be enacted, we see the potential for credit default swap contracts to rally massively," Bank of America analyst Glen Taksler said in a report sent late on Thursday.

The contracts would likely be transferred entirely to the higher quality municipal business, or be split equally between the municipal and structured finance divisions, he said.

Bond insurers sell insurance on municipal debt and collateralized debt obligations, and their ratings have come under pressure due to losses they are expected to take from mortgage securities in their CDO portfolios.

As their ratings have come under threat, or in some cases lowered, their debt protection costs have surged over concerns the companies will no longer have a viable business, raising the risk of a default.

For example, the cost to insure the debt of the bond insurance arm of MBIA Inc (MBI.N) has surged to 486 basis points, or $486,000 per year for five years to insure $10 million in debt, from below 100 basis points last September, according to Markit Intraday.

SUCCESSION

The cost to insure FGIC's debt fell on news of its split to around 18.5 percent the sum insured as an upfront payment, or $1.85 million to insure $10 million for five years, in addition to annual premiums of 500 basis points, or $500,000, according to data by CMA DataVision. The swaps had traded on Thursday at around 25 percent the sum insured upfront, plus the annual 500 basis point premium, CMA said.

Bank of America's Taksler analyzed the debt that underlies credit default swaps on bond insurers and found that splits by FGIC and MBIA are the most likely to result in the contracts being transferred to the municipal arms.

The bond insurance arms of Ambac Financial Group (ABK.N) and Security Capital Assurance SCA.N are likely to see their credit defaults swaps split between the two entities, though in the case of Ambac the calculations are borderline.

The estimations are also complicated as the amount of CDOs that back the contracts is difficult to determine, and this calculation will play a part in whether or not the contracts transfer to the new entity, Taksler said.

When a borrower defaults on its debt, which triggers payment of a swap, buyers of protection on the entity are paid the amount insured by the protection seller. In return, the seller receives the defaulted company's debt and benefits from how much principal the debt recovers.

In the case of bond insurers, however, sellers of protection may be given debt that is guaranteed by the defaulted insurer in order to settle the contract, and these options vary widely, from highly rated municipal debt to CDOs battered by risky residential mortgages.

If more than 75 percent of the debt underlying the credit default swaps on bond insurers is transferred to a new division, such as a separate municipal insurance business, then the credit default swap will succeed entirely to that new division, Taksler said.