Standard & Poor's Research: An Analysis of the Sale of FGIC
Standard & Poor's Ratings Services affirmed its 'AAA' financial strength rating on Financial Guaranty Insurance Co. (FGIC) following the announced agreement to sell the company.
FGIC will be sold by General Electric Capital Corp. (GECC 'AAA' senior debt rating) to a group of investors led by The PMI Group Inc. ('A+' senior debt rating/negative outlook). Although dividend payments to GECC in connection with the sale will reduce FGIC's statutory capital to about $1.8 billion on a pro forma basis as of Sept. 30, 2003, compared to $2.0 billion as of Dec. 31, 2002, FGIC will remain comfortably in compliance with Standard & Poor's 'AAA' capital requirements. FGIC's capital adequacy margin of safety on a pro forma basis falls in a range of 1.4x to 1.5x. This result is consistent with the 'AAA' industry average.
Under the ownership of the new investors' group, underwriting activities for FGIC will be expanded. Historically, the company's goal of having the lowest-risk insured portfolio in the financial guaranty insurance industry resulted in business activity largely focused on essential-use public finance sectors, such as general obligation, water and sewer, sales and excise tax-backed, and transportation. In the asset-backed market, FGIC has selectively participated in the mortgage and home equity loan sectors.
Looking ahead, the new business plan essentially provides for entrance into any domestic or international market where risk/return considerations are consistent with the company's continuing goal of a low-risk insured portfolio. In the domestic public finance area, the company remains committed to a goal of having the lowest average capital charge in the industry. Nevertheless, there is sufficient margin relative to historical underwriting standards to allow for broader public finance participation. Over the next several years the plan calls for measured expansion into the municipal electric, hospital, housing, student loan, and investor-owned utility sectors. In the domestic asset-backed market FGIC plans to broaden its participation in the MBS area to include prime and sub-prime mortgages, home equity loans, high loan-to-value loans, and commercial MBS. Other new lines of business would be auto loans, consumer debt and student loans, and CDOs. Internationally, similar to the business plans of most competitors, FGIC will target infrastructure and private finance initiatives in the U.K. and European Union, as well as non-domestic CDO opportunities.
Entrance into these new sectors will not happen overnight. In many cases additions to staff with the necessary expertise will be required. Standard & Poor's expects that these new lines will be conservatively underwritten, taking comfort in the company's history of prudent overall risk management. We will also meet with FGIC management to review detailed underwriting, business, and origination guidelines, as the company gets closer to entering a new sector. From an operational and strategic perspective, FGIC will benefit in that all existing senior managers will remain with the company. In addition, Frank Bivona, formerly vice chairman and chief financial officer with Ambac Assurance Corp., will join FGIC as chief executive officer.
The lead investor of the buyers' group is The PMI Group. GECC will also remain as a minority equity investor. The PMI Group's operating companies are principally involved in writing mortgage insurance. The mortgage insurance units are rated 'AA+'/Negative and the PMI Group is rated 'A+'/Negative. PMI has long publicly indicated its interest in expanding further into financial guaranty insurance. Its track record as a strategic investor in financial guarantee reinsurance company RAM Reinsurance Co. ('AAA' financial strength rating) is favorable. PMI management has characterized the expansion into financial guarantee as a logical extension of its mortgage insurance franchise.
There are three remaining owners:
Although Standard & Poor's favors ownership by a large majority of highly rated strategic investors, Blackstone, Cypress, and CIVC/Bank of America are characterized as financial investors. Historically, we have observed that financial investor decisions are sometimes heavily weighted in favor of their investment return, at the expense of policyholder interests. Nevertheless, this particular ownership structure and group is viewed as acceptable. Standard & Poor's spoke with all the financial investors, and, relative to prior experiences, these owners are generally more sophisticated, have better track records, and better understandings of the importance of maintaining FGIC's 'AAA' rating. Furthermore, policyholders will benefit from a number of independent board members. In addition to the appointment of a non-executive chairman, both Blackstone and Cypress have expressed the intention of making one of their three directors an "independent."
The financial investors are motivated by an exit strategy that expects an initial public offering in several years to be priced at a fractional multiple of their investment. Participation in more profitable business lines, combined with better pricing discipline and selectivity in historical sectors, supports this expectation as does the introduction of debt and hybrid-equity leverage at the holding company, which will aid return on equity results.
FGIC's capital adequacy margin of safety on a pro forma basis falls in a range of 1.4x to 1.5x. This result is consistent with the 'AAA' industry average. Although dividend payments to GECC will reduce the company's statutory capital to about $1.8 billion compared to $2.0 billion as of Dec. 31, 2002, FGIC remains comfortably in compliance with 'AAA' capital requirements and exceeds Standard & Poor's 1.25x minimum requirement. In addition to the lower statutory capital number, the new margin of safety incorporates a higher capital charge expectation versus historical business for the company in the public finance sector, as well as growth and expected capital charges and premium rates for new business lines. As of Dec. 31, 2002, FGIC's margin of safety was in the 1.5x to 1.6x range. FGIC's claims-paying resources continue to include a $300 million soft capital facility from GECC, although the former parent has indicated that it wishes to be replaced as a soft capital provider as soon as possible.
In order to improve equity-based returns, holding company FGIC Corp. will be adding debt and preferred stock to its overall capitalization. In addition to about $1.4 billion of common equity, FGIC Corp. will be capitalized with $236 million of debt and $234 million of participating preferred stock. The preferred is viewed as predominately equity-like in that it may only be redeemed through the issuance of common equity. In addition, it is mandatorily convertible to common stock in nine years. Other features of the preferred are its dividend rate of 6.875% per year, and dividends that are payable in-kind (PIK) and are non-cumulative. Also, the PIK dividends are limited to operating earnings and the preferred ranks junior in right of payment to all indebtedness.
The holding company will also be capitalized with $226 million of debt. Initial funding will take place using a bridge loan. Subsequently, it is expected that FGIC will repay the bridge loan with a longer-term capital market issue. Pro forma debt to total capital is about 14%.
For the new FGIC Corp., financial flexibility--the company's ability to raise cash internally or from owners or the capital markets--is an issue requiring greater attention relative to when the company was wholly owned by GECC. In the context of its new, albeit still reasonably conservative, business direction, the financial investors are viewed as a less reliable source of future capital. Compounding that dynamic is the absence of a track record of public debt or equity issuance. Also, the need to replace GECC as soft capital provider for FGIC is a further stress on overall financial flexibility.