The Wall Street Journal Fulminates About Dinallo

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.

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  1. Scooter99

    See the news yesterday about the town of Vallejo (sp) in the Bay area on the verge of bankruptcy? Muni insurance may not be the safe bet everyone thinks it is when munis face falling tax revenue and have to pay generous benefits that the unions have negotiated. Think what would a cut in monoline provisioning in such an environemnt do to the value of such insurance.

    Why I don’t understand is why the monolines would ever go for such a deal. The muni business is the safe, profitable aspect; the CDOs etc. are crap. Why would they give up the good stuff and keep the bad? Also, once they exit the business, they will not be able to re-enter, especially if Buffet et al set up competing shops.

    As I see it, the only thing they can do is take their lumps and stop writing the bad insurance. To survive, they will need massive capital infusions AND government help. By rights, they should go bankrupt but the damage to the financial system and to a wide range of players. While no one will shed a tear over BSC, the Florida Teachers’ Pension fund is another matter.

    And that is the problem I have with the Roubini-esque analysis. It’s spot on, but comes to the conclusion that should be, not will be. The government and powers that be simply will not allow it. Look at the Latin American crisis and the fiction they invented called Brady bonds. The situation now is not that dissimilar.

  2. RK

    “In the process he’s helping to abrogate private contracts, and may make the credit crisis worse”.
    Ooh, that would be veddy veddy bad! Well then, lets just leave the pot to simmer for a few more months, shall we? Let the market find it’s own solution. Or we could encourage “faith based” groups to lend a hand. Maybe all those wayward
    SIV’s CDO’s CLO’s could be born again. As I’ve always said, man in the only creature whose health
    improves after taking a placebo.

  3. Independent Accountant

    “Abrogate private contracts”? Wall Street advocates that every day through its apparent agent. Hank Paulson. I read the WSJ’s editorial and was not impressed by it either.

  4. Anonymous

    “… their companies grew their businesses smartly…”

    Smartly. That’s the tell tale word in this WSJ editorial. The WSJ doesn’t give a hoot about the sanctity of contract. They care for one thing and one things only: greed.

    Smartly. Only a passionate commitment to a fact-free and analysis-free ideology of greed for its own sake could support the use of this word to describe what the insurers did here.

  5. Anonymous

    “smartly”…that got a big chuckle out of me. That was a sure fire way to strip any credibility from the author.

  6. Anonymous

    I love to bash newspapers too, but is anyone going to criticize the point. That segregating politically undesireable policyholders in an undercapitalized structure unable (by design) to pay their claims to protect politically favored policyholders is wrong. Second, anonymous latched onto the wrong connotation for smartly; here it is used to mean quickly. Anonymous is the one using fact free, low credibility analysis here. At least disagree with what they wrote. Don’t misunderstand and criticize something that wasn’t said.

  7. Francois

    “Mr. Dinallo, egged on by Mr. Spitzer, says that the interests of state and local government policyholders should come before those in private business.”


    I guess these clowns have gotten so used to the Federal government (namely Congress) favoring private wealth at the expense of the common good that they now consider this situation as a God-given right.

    Oh my!

    When the monolines were solely in the muni insurance, they had the highest revenue per employee on the PLANET. Their risk-adjusted profitability was way north of anything else in the financial industry. But there was one little problem; the business lacked sex-appeal. It was very hard for these guys to impress anyone at the cocktail party when introducing themselves with: “I’m in the municipal insurance business”. Talk about a snoozer!

    Bored out of their wits, prodded by greed and ego, they “smartly” expanded in a line of business they clearly had no idea how it worked. Talk about smarts…Several years later, here we are, knee-deep in a mess with no historic equivalent.

    And of course, the Ed board of the WSJ wants the taxpayers to, once again, bail out the financial BS from the ego-driven idiots (that would be management of the monolines) who are in no small part responsible for this cluster of you-know-what.

    Public good at the service of private interests? Only when ALL private interests are served…and that MUST include you and I, the taxpayers!

  8. Anonymous

    I have experienced the “Free Ride” problem:

    A vehicle hit a fire hydrant in front of our house. And adjuster called a restoration company to help out. It turned out that the owner of the restoration company was the vehicle’s owner. The restoration company screwed the job by adding more more hummidity into he house. Our insurer made repairs but wont release costs for the work done – they hired the restoration company…we cant sue the vehicle’s owner because again no quantum on the costs. We are out about 50k. Oh well.

    I have a new saying: Crime does not pay, Insurance does.

    Based on my experience and in my opinion, the only thing an insurer will do is cover its petard and deny everything.

  9. Anonymous

    ” Messrs. Spitzer and Dinallo are only creating more mistrust and uncertainty. “

    The WSJ became a puppet mouthpiece when it let itself be bought.

    If banks cared one whit about mistrust and uncertainty, they would mark their level 3 portfolio to market and observe how insolvent they actually are. Investment bankers only prattle on about trust and faith when it would benefit them for someone else to be revealing.

    I don’t buy this at all. The fact that banks are dragging out this tired refrain shows the true state of the monolines — it’s even worse than Ackman’s claims.

  10. Independent Accountant

    There has been a theory pushed recently that if the monolines were split some of the banks might sue under the “fraudulent transfer” law. There’s a problem with this theory. To void a transfer under it you need prove the entity was insolvent at the time of the transfer or had an unreasonably small capital. Can you imagine the same banks which are trying to bail out the monolines arguing this? I agree with Ackman, the monolines are a disaster area.

  11. S

    Isn;t it interesting that all of a sudden the monos got religion and want to slpit. Any split if allowed should be accompanied by a full replacement of the board. If the management teams are allowed to stay intact it will be the gravest injustice of all. These guys are worse than used car salesman in there transparent attempts to save their own skin.

  12. S

    …on the taxpayers tab

    The funny thing about this whole debacle is that the pundits pass off the excess as a one time item and then are ready to value the economy on a normalized basis next quarter in typical Wall Street fashion. That trade will be proven bankrupt.

    The early cycle trade crowd is really tragicomic. Tragic because these people actually believe it. I mean seriously, the best we can do is facebook/myspace only to have google come out and say we are having diffiulty monotizing social networking. No, you don’t say. Say what you want of the military industrial complex but at least it produces things, American. We are having back channel meetings with Chinese retired Generals (FT today) to sooth rising tension. The US needs a serious ass kicking and even that is a longshot.

  13. Anonymous

    What I find surprising is that no media outlet has examined Article 74 of the New York State Code, specifically 7402 which enumerates grounds for rehabilitation. No media outlet has interviewed an insurance legal expert.

    Scanning 7402 I noted:

    Dinallo needs to convince a court to order rehabilitation, and he needs to provide that court with a plan of what he intends to do.

    Grounds include failing to obtain capital deemed necessary, but I am not clear whether Dinallo would need to get a court to declare that additional capital would be necessary beforehand.

    One explanation is that the monolines think that they Dinallo could successfully argue that they are insufficently capitalized and hence require rehabilation. If splitting off the SF business is the only way to attract fresh capital, the monolines will do it.

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