Let No Man Rent Asunder

Eric Dinallo, New York’s insurance superintendent, testified today at a hearing of the House Financial Services subcommittee. Both the FT and Bloomberg report various parts of his evidence. The FT first:

[Dinallo] said on Thursday that a government bail-out of troubled bond insurers ”is not planned”. [...]

Mr Dinallo, told lawmakers that finding a solution to allow Ambac, MBIA and others to maintain triple-A credit ratings on which their guarantee business depends was an ”extraordinarily difficult problem”.

Certainly he wins marks for honesty on the latter point. But according to Bloomberg matters got more interesting:

New York regulators may consider splitting bond insurance companies into two businesses to protect municipal debt from losses on subprime mortgage securities.

How could this possibly work? It does not suffice simply to split the liabilities: you have to split the assets too. Presumably any split would have to be equitable to equity holders (and to senior debt holders), so equity would have to be split pari passu with risk. But estimating the economic capital required for a large monoline is about as difficult a problem as we have in financial modeling at the moment, especially given that the muni business diversifies the structured finance business so the standalone capital requirements of the two pieces are more than those of the original whole. Moreover does Dinallo really have the power to do this if shareholders are hostile?

Update. Eliot Spitzer has upped the anti. According to the FT, he has given the bond insurers three to five business days to find fresh capital, or face a potential break-up by state regulators who want to safeguard the municipal bond markets. Oh, and Moody's has downgraded FGIC. So no pressure then. At least we can watch the auction market fall apart while we wait. And join Paul Krugman in speculating on what's next.