naked capitalism

Full disclosure: I am no fan of the Wall Street Journal’s editorials: in fact, I’ve commented on the liberties they often take with facts. But when they are on a pet peeve, they can become so overwrought that the level of agitation alone is amusing. And just because they are often wrong doesn’t mean they are always wrong.

Today’s object lesson is a rant about New York insurance superintendent Eric Dinallo’s plans to break up the bond insurers. A big reason for their wrath is that they are still steaming over the wrongs they felt former New York attorney general visited upon hapless Wall Street firms. As a New York resident, my main beef against Spitzer was he did expend a bit too much effort on financial misdoings and left important unfinished business, like the health insurance industry’s creativity in not meeting their contractual obligations, to his successor Andrew Cuomo.

First, the Journal editorial, “Son of Spitzer,” then a few comments on it:

You buy an insurance policy. A tree falls on your roof. Then your state’s insurance regulator calls you in for a meeting. He tells you that some people will say that you should have cut down that tree. He suggests that you and all the other homeowners likely to submit claims should join together and send a big check to your insurance company to help pay for repairs.

If that sounds bizarre, well, something like it is playing out in the state of New York. State Insurance Superintendent Eric Dinallo, a protege of Governor Eliot Spitzer, has caught his boss’s zest for meddling in private markets without much wisdom and is venturing beyond his explicit legal authority. In the process, he’s helping to abrogate private contracts and may make the credit crisis worse.

Bond insurers, including Ambac, MBIA and FGIC, sell policies to the issuers of securities to cover interest and principal in case a borrower defaults. These companies grew their businesses smartly during the credit boom by venturing beyond their traditional municipal business and into riskier securities backed by home mortgages. Like so many others, they are now finding that they underestimated how many borrowers wouldn’t pay back their loans. Mr. Dinallo is concerned that if the bond insurer’s credit ratings slip, so will the ratings on the municipal bonds they insure, causing many investors to sell these bonds.

Mr. Dinallo, egged on by Mr. Spitzer, says that the interests of state and local government policyholders should come before those in private business. This is of course news to the private companies that bought this insurance. Primarily Wall Street banks, they have also been encouraged by Mr. Dinallo to invest $15 billion in the bond insurers. If the banks decline this “suggestion,” the insurers may be split and Wall Street’s policies will be placed in companies with less ability to pay claims.

First question: What authority does Mr. Dinallo have to tell banks, or anyone else, to invest in bond insurance companies? None, according to Mr. Dinallo. He says that, as a lawyer who used to work on Wall Street, he was simply making a helpful suggestion and “was not trying to threaten” the banks. He also suggested that if the banks didn’t ante up, the media would take the view that Wall Street was not helping to solve a mess they had created.

A spokesman for Mr. Dinallo says that the investment banks enjoy “free will” and can ignore him. The spokesman added, speaking of the banks, “Some of their choices may be shaped by the decisions we make. We all have to live with the consequences of the decisions we make.”

Mr. Dinallo has made the “consequences” crystal clear, blessing plans to split bond insurers in two: a highly rated company to take care of his colleagues in state and local government, and a lower-rated company to provide for the private market.

Splitting up the companies seems a strange way to reduce risk, given that the whole idea of insurance is to limit individual policyholder risk by expanding the pool of insured. Such a split could make sense if an insurer faces insolvency, but Mr. Dinallo says he does not believe any of the bond insurers is facing insolvency.

Second question: Does New York law mandate that Mr. Dinallo put the interests of government bond issuers above those of private issuers? No, according to Mr. Dinallo. So what we really have here is a politician and his boss (who is otherwise in political trouble) pandering to government interests by once again bashing “Wall Street.”

A financial system runs on trust, and the credit crisis is continuing in part because there is so much mistrust about the magnitude of potential losses and where those losses reside. By encouraging bond insurers to unilaterally rewrite their contracts, Messrs. Spitzer and Dinallo are only creating more mistrust and uncertainty. We assume the banks that bought the bond insurance and signed the contracts will take their insurers to court.

The tree/house analogy is misleading. It completely misses the fact that the homeowners will suffer a lot of additional damage if the situation isn’t remedied. But asking the few (relative to the total number of policyholders) to kick in for a rescue creates a huge free rider problem.

But while the piece plays a bit too heavily on how badly wronged Wall Street is in this picture (ahem, there are a lot of investors in these products who will take a lickin’ too, and most of them don’t have fat bonuses to salve their wounds) and gets a bit sanctimonious about the operation of private contracts, their points. once you cut through the bluster, do have merit.

We’ve said before a break-up will not solve the problem it is intended to address and will almost certainly make raising new capital harder. We’ve said that Dinallo lacks the authority to force this program upon the insurers. However, since they are going along with his lead, including MBIA, which decided to oust defiant former CEO Greg Dunton, Dinallo can’t so easily be accused of being half-baked (even though we think the idea is half-baked) if the industry embraces it. And that also takes the steam out of the charge that Dinallo’s move was a Mafia-like threat to force the banks to make their best offer (after all, the concerted effort to pursue the break-up plan makes it look like a bona-fide initiative rather than ploy).

And we do think investors will sue if the plan goes anywhere.