Eliot Spitzer is doing what he does best--threatening regulatory interventions of dubious legality, in order to strongarm banks into donating money to his pet causes. In this case, that cause is the municipal bond authorities of New York State. Nicole Gelinas of the Manhattan Institute points out the problem with this:

State and local leaders across the country (and investors in their muni bonds) complain that they're being punished for something that's not their fault. Yes, there's always a risk to issuing bonds whose interest rates "reset" frequently - but one can hardly blame municipalities for not foreseeing this strange situation.

Spitzer and his insurance regulator, Eric Dinallo, think they have a solution. If big banks don't immediately pump billions into the bond insurers to make the market happy (or if the insurers don't capitulate to billionaire Warren Buffett's offer to simply buy out their muni-bond insurance business at a dear price), Spitzer and Dinallo say, they'll use their regulatory powers to let the insurers break up - that is, split their business in two, with "good" muni bonds in one company and "bad" mortgage bonds in the other.

But there are a few problems with that.

First, the state has a conflict of interest. It's a regulator, but also stands to lose money as an issuer of insured muni bonds. New York and its authorities have nearly a fifth of their outstanding debt in about $4 billion of "insured" bonds whose interest rates reset frequently - all of which could face millions in higher rates in even short-term turmoil.
So splitting the bond insurers into "good" and "bad" firms may make investors wonder if the state is thinking of itself, rather than thinking of all insurance clients as a regulator should. And some investors will likely sue.

After all, it's unlikely that the "bad" insurance company would survive after a split. That is, the firm that gets the mortgage bonds won't be able to pay out on its claims. People and institutions that bought subprime mortgages only because they, like muni bonds, came guaranteed with a AAA rating, will lose.

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