Bond Insurers May Face Breakup

New York Insurance Superintendent Eric Dinallo is considering a split-up of monoline bond insurers as one possible strategy to protect policyholders and insure the critical triple-A ratings of guarantors Ambac Financial(ABK Quote), MBIA(MBI Quote) and Financial Guaranty Insurance Co., according to testimony to be delivered on Capitol Hill Thursday afternoon.

Dinallo, who has been engaged in a frenzied pitch to save the financial guarantor market, suggested separating municipal bond policies "and any other healthy parts of the business" from "the structured finance and problem parts of the business," according to testimony obtained by TheStreet.com that Dinallo is expected to present to a subcommittee of the House Committee on Financial Services.

Dinallo emphasizes that his main priority is to protect the millions of state, city and other government policyholders that have obtained insurance on municipal securities.

"We cannot allow the millions of individual Americans who invested in what was a low risk," Dinallo says in his prepared testimony. "Nor should subprime problems cause taxpayers to unnecessarily pay more to borrow for essential capital projects."

A move to split bond insurers would essentially create two separate entities: one containing the insurance backing toxic structured products that threatens to topple the financial guarantors and another that would house policies supporting the staid municipal debt.

Monoline bond insurers guarantee debt on some $2.5 trillion in securities but have fallen on tough times because the esoteric, structured, subprime-tainted securities that they insured in 2006 and the first half of 2007 are souring as the mortgage market collapses.

Rating agencies Moody's Investors Service, Standard & Poor's and Fitch Ratings have been increasingly demanding that financial guarantors raise more capital to protect against losses or face downgrades. Insurers Ambac and FGIC have already been downgraded from triple-A to double-A by Fitch and now face more difficulties in running their businesses. MBIA has been on review for a downgrade even as it has found a partner in private-equity firm Warburg Pincus, which has provided it with fresh capital.

Splitting monolines also could further bolster muni debt that has been trading in the secondary market as if it did not have any insurance. But it comes at a cost to bond insurers because it would leave the guarantors with a big conundrum: Who takes the toxic structured products?

A decoupling plan being floated by Dinallo comes days after Warren Buffett offered to reinsure $800 billion in debt for Ambac, FGIC and MBIA. That plan, however, was extended only to the municipal bond business, which has a low probability of default. So far, the Buffett plan has been rejected by Ambac, and sources tell TheStreet.com that MBIA also has rebuffed the offer.

Dinallo indicates in his testimony that he reached out to Buffett's Berkshire Hathaway(BRKA Quote), which has launched its own bond insurance business, to help come up with a possible solution.

As superintendent of insurance, Dinallo has the authority to arrange a split-up of the monolines because they are headquartered in New York. The government official also has the authority to place the guarantors in a state of runoff, in which they take no new business and build up reserves by collecting the premiums from their existing book of business -- a move that would protect policy holders from losses.

The notion of a split of Ambac, MBIA and FGIC, however, suggests that Dinallo might also be considering forcing the companies into runoff.

"We now are considering whether the sustainability of the business model should be the regulatory standard going forward. While we of course consider claims paying ability as the benchmark, our goal for the future, for all insurers, is to do higher level risk-based examinations," Dinallo's planned testimony reads.

The hearing, titled "The State of the Bond Insurance Industry," also is expected to feature testimony from New York Gov. Eliot Spitzer, officials from MBIA and Ambac and activist investor Bill Ackman, who has been critical of the industry.