I hate to say it (because I don't think this will make you feel any better about the situation), but it sounds and looks as though this is the result of a parasite infestation. The larvae of the parasitic insect (I'd guess braconid wasps) were feeding inside the caterpillar, and they emerged and started spinning their own pupal cocoons in that cottony mass, as some will do. The caterpillar is probably not going to survive long after this.

So, the "babies" will probably turn out to be tiny wasps after they pupate. Not a type that will sting people, and they are generally considered beneficial insects that naturally reduce plant pest populations.

REALLY? I can deal with wasps. And yes, the caterpillar died not long after. We are keeping the "stuff" in a jar to observe. I'm excited to see what emerges. Thank you for your help.

This type of parasitism is fairly common on caterpillars.

I guess so. Another caterpillar we gathered (southern dogface, possibly) did the same thing. Now my daughter is a little freaked out. But I am interested to see what happens next.
Thanks for all your help!

A way to avoid this is to collect the caterpillars when much younger (fewer instars), but of course you need a suitable container and hostplant material. Many people even gather specimens at the egg stage, just after being laid by the adult insect. Also, mail-order kits would be uncontaminated.

Mail order kits would be an amazing idea. My kids LOVE collecting insects and observing them. Are there good companies out there to order from? Although it does take the fun out of finding... And I've never been able to find butterfly or moth eggs on plants. Tried, and failed. I am always amazed by the people who do find the eggs, and raise them to adulthood.
It seems like we have a good chance of any caterpillars we find being hosts.
My daughter hatched and grew painted lady butterflies in class a couple years ago, but I never found out where her teacher got the eggs and food.
Thank you. I'll look into that.

This post was edited by adnahs on Wed, Aug 28, 13 at 0:32