Bond Insurer Bailout a Bad Bet

A bank-sponsored bailout of the troubled bond insurance sector seems more like wishful thinking than market savior.

Rumors leaked Wednesday of a massive rescue plan led by New York Insurance Superintendent Eric Dinallo drove the tattered shares of financial guarantors MBIA(MBI) and Ambac Financial (ABK) through the roof, but the cold, harsh reality of the complexities of such a move is now starting to smack the stocks again.

Ambac shares were down 17% after seeing a 72% rally Wednesday and MBIA shares were trading down about 11% after soaring 33% the day before.

Cramer: Bond Insurers Still Worth Nada

"Clearly it is important to resolve issues related to the bond insurers as soon as possible," Dinallo wrote in an emailed statement. "However, it must be understood that these are complicated issues involving a number of parties and any effective plan will take some time to finalize."

Dinallo declined to comment further through a spokesman. "Complicated," however, is perhaps understating the fact that some of this insurance provided by these once obscure firms, now at the eye of the credit storm gripping Wall Street, is meant to backstop losses on now-shaky debt structured -- in some cases literally -- by rocket scientist cum bankers.

"Ultimately, nothing may come of it, but at least he is actively engaged," Thomas Abruzzo, managing director at Fitch Ratings tells TheStreet.com. "[Dinallo] doesn't have broad powers per se, but he is in a position to get some people talking and I think that that's a starting point," he adds.

Scuttlebutt on the Street yesterday implied that the subprime-battered wonder twins Citigroup (C) and Merrill Lynch(MER), among others, might pony up billions to help out the guarantors, also known as monoline insurers.

Citi and Merrill and a host of financial institutions should indeed have an incentive to try and prop up the troubled firms, considering that they act as counterparties, providing additional protection for investors in the form of derivative securities known as credit default swaps that could amount to big losses for them should the guarantors go under.

But involving firms already swooning from their own misadventures in finance would be a laughable notion, given that both Citi and Merrill have racked up tens of billions in losses tied to mortgage-tainted securities, forcing them to turn to foreign and domestic investors to raise cash to shore up their own balance sheets.

Given the enormity of the subprime crisis for Wall Street, Whitney Tilson of T2 Partners says Dinallo's potential move isn't surprising, but adds, "it's far from clear that he will be successful and, if he is, it will likely be on terms that would be onerous at best and disastrous at worst for shareholders," in an emailed note.

At stake for monolines is some $2.4 trillion to $2.6 trillion of municipal bonds and structured debt, such as collateralized debt obligations or CDOs, that have plummeted in value as credit markets have dried up. By many accounts, there could be a ripple effect for the financial markets if monolines suffer further downgrades to their credit ratings, as such debt would become riskier to own.

Fitch Ratings on Thursday slashed the triple-A rating of Security Capital Assurance (SCA) subsidiary XL Capital Assurance to single-A from triple-A, after it abandoned plans to raise some $2 billion in cash. Fitch also downgraded SCA itself from double-A to triple-B.

Last Friday, Fitch also downgraded Ambac from triple-A to double-A. The ratings agency has appeared to be the most aggressive of the big three ratings firms in its scrutiny. Moody's Investors Service and Standard & Poor's have not yet responded with their own downgrades of monolines, but Moody's has threatened to cut MBIA's triple-A rating.