A proposal has been made to use a portion of the monies available in the recently announced federal bailout to assist the financial guaranty industry incorporating the "good bank, bad bank" model.

Proponents of this approach point out that this technique was used successfully in the 1930s with commercial banks, and more recently in the insurance industry. However, even if this approach is successful in allowing the financial guaranty companies to shed their "bad bank" exposure, they would still be faced with two major conundrums, namely the return on capital problem and the rating agencies' response. Combined, these two factors pose a serious risk to the success of any plan.

In the early 1980s, the industry charged premiums between 100 and 125 basis points on the most creditworthy general obligation municipal issuers. The underwriting process was conducted on a strict "no loss" basis, as these companies perceived their role more as "improving the marketability of good credits" and not "making a bad credit good."

Over time, however, increased price competition from new entrants resulted in a rapid deterioration of premium rates that ultimately reached single digits. In this environment, the industry watched as their return on capital for much of their core businesses significantly deteriorated.

An example of this is illustrated by General Electric Co.'s attempt to sell Financial Guaranty Insurance Corp. Prior to its sale, the return on capital for FGIC was reported to be in the 6% to 8% range. This was a contributing factor to the difficulty experienced in selling the company.

Seeking to maintain profitability in a competitive environment - an issue raised by the rating agencies - led the financial guaranty companies to insue transactions outside their core business model, including asset-backed and mortgage-backed obligations and collateralized debt obligations.

For a period of time, this approach was successful. However, we now know this was not a prudent business model. Given this fact, if financial guaranty companies are allowed to return to a "municipal only" model, a model where single to low double-digit premiums are the norm, how will they be able to attract sufficient equity capital?

Perhaps the most significant obstacle is the one posed by the rating agencies, who are desperately dealing with their own crisis of confidence.

Assuming the financial guaranty industry could resolve all of the "good bank, bad bank" exposure issues, and somehow address the profitability issue, they would still need to regain their triple-A credit ratings. At a time when the heads of the major rating agencies are testifying before Congress over their handling of the current financial crisis, it does not seem likely they will be handing out triple-A ratings anytime soon.

The authors represent HRF Associates. For more information, contact Robert Smith at RSmith@hrfassociates.com or 530-620-7128.