Bond Insurer Foe Floats Breakup Plan

Activist investor Bill Ackman has submitted a breakup proposal for ailing bond insurers Ambac Financial(ABK Quote) and MBIA(MBI Quote) that could earn him billions by driving the insurers' parent entities into bankruptcy.

Ackman's proposal -- a 13-page PowerPoint presentation obtained by TheStreet.com -- could protect policy holders from big losses if structured debt that guarantors insure default. It also may save banks and brokerage firms such as Merrill Lynch(MER Quote) and Citigroup(C Quote), which are also linked to bond insurance, from facing bigger losses and writedowns on soured debt.

But the proposal comes from an odd savior in Ackman, who as head of hedge fund Pershing Square Capital would generate billions if Ambac and MBIA go bankrupt. Ackman has been one of the most dogged opponents of financial guarantors since 2002. He has publicly stated that he would donate profits from his short bets to charity.

The fund manager declined to comment for this article.

Ackman's proposal would see bond insurers such as MBIA, Ambac and closely-held Financial Guaranty Insurance Co. split into two firms each, with assets representing policies backing municipal bonds and other conservative contracts comprising one component and toxic structured debt housed in a separate entity, creating a "good insurer/bad insurer model."

The plan calls for dividends to be directed to the bad insurer business in order to provide a buffer against future claims until the structured product unit, which consists of esoteric mortgage debt known as collateralized debt obligations (CDOs) and asset-backed securities (ABS) that have fallen precipitously in value since last summer, steadies.

Ackman has long argued that guarantors should not be paying dividends to their parent companies, as they currently do, if they are considered to be in financial distress.

Bond insurers back some $2.6 trillion in debt from municipal bonds -- a little more than half of that insurance is offered to towns, cities and local governments so that they can obtain debt more cheaply in the public markets. But since early 2000, financial guarantors, who use their high-credit ratings to backstop against defaults, have turned to providing insurance on newfangled mortgage securities such as CDOs and ABS.

Fallen values in that esoteric paper has caused rating agencies Moody's Investors Service, Fitch Ratings and Standard & Poor's to call for bond insurers to raise billions to protect against potentially damaging future losses.

In his presentation, Ackman argues that his decoupling plan would protect muni bond holders and the credit rating of the "good" half of the split insurer from losing its triple-A rating. At the same time, it allows the structured side of the business to attempt to maximize value for policyholders by siphoning dividends generated by the more stable side of the business "until the policyholders are made whole."

A breakup of embattled bond insurers is nothing new. It has been floating around publicly since last week, when New York Insurance Superintendent Eric Dinallo met on Capitol Hill and presented a breakup as one possible strategy to protect policyholders and insure the critical triple-A ratings of guarantors.

"We cannot allow the millions of individual Americans who invested in what was a low-risk investment lose money because of subprime excesses," Dinallo said in prepared testimony delivered to a subcommittee of the House Committee on Financial Services about the state of the bond insurance business.

Bond insurer woes have been a big issue not just for the guarantors and the banks that could face bigger writedowns, but the municipalities who have been forced to pay richer interest rates on debt to build bridges and repair roads.

Dinallo has been trying to orchestrate a solution over the past few months, including bringing in the likes of billionaire investor Warren Buffett. The Oracle of Omaha has offered to reinsure $800 billion in debt that the ailing insurers back, but it would essentially leave the policyholders of the structured debt out in the cold and potentially put the monoline bond insurers in a state of runoff, where they underwrite no new business and collect premiums on their existing contracts.

Ackman claims to solve that issue with his proposal. The hedge fund manager also suggests a separate board makeup for the two separate insurance business that would best represent the specific policyholders and shareholders of the new entities.