There are a variety of interested parties with an interest in keeping the guarantors in one piece, as is pointed out in this article from Bloomberg. Downgrading half a trillion of asset-backed bonds if a split happens? Yes, that is the price, and that is why there will be many lawsuits to contest any split, as pointed out by naked capitalism. The discussion of that post is worth reading, because it got me thinking about the differences between swaps and insurance. There are two ways to go here:

1. A swap that mimics the nature of an insurance contract is an insurance contract. After all, that is the way their regulators have been behaving, at least up until now.
2. A swap is a side agreement between the operating company (the actual insurer, not the parent holding company MBIA or Ambac), and the counterparty. In liquidation, they would be treated at general creditors, behind the policyholders in liquidation preference.

I looked at a few of the relevant state legal codes yesterday, and if the state regulators want to play hardball, they would go with the second interpretation, and pull the rug out from under the feet of those who were relying on the first interpretation. They could argue that swaps are a different class of business than insurance, and try to make the case that if an insolvency occured, those with with swap contracts would face a much lower recovery than those with insurance contracts, so let’s make it formal and do a split.

Now, most of the business done was by insurance contracts, and the laws on rehabilitation, conservation and liquidation indicate that similar parties are to be treated equitably within each class of claimants. Policyholders are all in the same class. Splitting the companies into municipal insurance and everything else would not treat all policyholders equally. Thus the lawsuits.

Now for a few links:

• Roger Ehrenberg at Information Arbitrage sees the issues clearly.
• FT Alphaville features my comments, and adds to them.
• Good interview by Chris Whalen of David Kotok discussing the furor in municipals at present.
• For wonks only: from Stroock & Stroock & Lavan, a discussion of how derivatives are treated in insurance insolvencies. Yes. I actually got out my old insurance law books this afternoon, but they were no help. Interesting article that would support the hardball case.

As I’ve said before, I would not be bullish on the equities of the compromised financial guarantors. They may survive, but only after much dilution. Now we have Ambac trying to raise $2 billion. What will they use? A rights offering? A PIPE? Mandatorily convertible debt? Surplus notes at their operating insurance companies? In order to get cash today, they have to give up a lot of the potential profits of the business. And what, will they take the $2 billion to try to buy off the structured securities claimants? Not enough, I think, if that half-trillion figure is correct, with $35 billion of mark-to-market losses for the market as a whole (Ambac’s portion would be big).

Two last notes: legally, I don’t see how splitting the guarantors gets done. It flies in the face of decades of contract law regarding insurers. Second, wouldn’t it be a troubling unintended consequence if the regulators managed to protect the municipalities, and in the process, ended up destroying the investment banks, leading to a bigger catastrophe?

With apologies to Mr. Krugman, I must correct some of what I wrote in my piece, “Pushing on a String? Credit Marches to its Own Drummer.“  When one does statistical analyses, one needs to understand the limitations/features of the tools that one uses.  Bloomberg’s regression function had a funny default that led me to make an error.  Had I done it right, the R-squared over the full sample period would have been 64.8% (correlation 80.5%), with a beta of 0.614.  Lagging the Fed funds target by one year, roughly the time it takes Fed policy to work boosted the R-squared to 77.2% (correlation 87.9%), with a beta of 67.1%.

But, here ‘s what is unusual.  If one is looking at the last five years, the relationship has broken down.  During that period, with no lag, the R-squared was 11.2% (correlation 33.5%), with a beta of negative 13.0%.  Even with the lag, the R-squared was 3.8% (correlation 19.4%), with a beta of negative 3.7%.

My conclusion: given the unusual credit conditions in the 2000s, where we have had extremes of default and monetary policy, I would not rush to say that the Fed is pushing on a string, yet.  That said, the debts of financial companies are a larger part of the index than they were five of ten years ago, and they are the ones in trouble at present, unlike the prior difficulties in industrials and utilities in 2001-2003.  Because of that, the Baa index of Moody’s may lag longer than ordinary versus Fed funds… but Fed policy has been called impotent before, and usually just before it shows its bite, as in the tech bubble of 2000, or the liquidity rally of spring 2003.

To my readers: if you see something that might be amiss in my writings, post a comment.  I owe it to all of you that I post corrections when I make mistakes.  Thanks for bearing with me on this one.  In the original piece, I sounded more certain than I should have, to my detriment…