Should Firms Be Allowed To Just Spin Off Their Losses?

A New York Supreme Court judge has ruled that Wall Street banks' lawsuit against bond insurer MBIA won't be dismissed. The banks are angry because they believe MBIA used illegal tactics to shield some of its assets from making good on its insurance contracts on securities that went bad. Even though regulators approved of how MBIA split itself into two entities, banks think they should still be entitled to damages. While this is tricky as a matter of law, I agree in principle.

Let me provide a little background. MBIA insures different kinds of bonds. For example, it can insure a municipal bond so that investors incur fewer losses if the bond goes bad. It happened to insure a large number of mortgage-backed securities and other structured products, many of which suffered big losses when the housing market collapsed. As a result, the company began having trouble living up to all of its guarantees: it hadn't anticipated such a calamity and didn't have the necessary capital to absorb the associated losses.

As a result, it split the company into two parts: one for its municipal bond business and another for everything else, including the toxic bond guarantees. Bloomberg News explains:

MBIA created the National Public Finance Guarantee Corporation, which assumed $5.4 billion of the MBIA Insurance Corporation's assets and its public finance obligations. MBIA's structured finance guarantees, including those related to mortgage securities, remained the obligation of the MBIA Insurance Corporation.

The banks and investors holding insured toxic bonds were not amused. They believed that they should have a claim on those $5 billion in assets that MBIA split off to create a focused municipal bond insurance arm. That's why they sued.

This is a difficult case, because, inexplicably, the move was approved by a regulator, the New York State insurance superintendent. If a regulator says it's okay, how could MBIA be breaking any laws?

As a matter of law, I'm really not sure what should happen in this case, because the problem I see here is that a regulator should never have approved of this tactic. It was unfair to those who believed that the guarantees on the bonds they purchased would be backed up by all of MBIA's assets. After all, if they'd known that some $5 billion in assets would be shielded from their claims, then they probably would have viewed the insurance less favorably.

A company should not be able to just split itself up so to shield its assets from its losses. In an economy where firms are becoming more and more diversified, you can begin to imagine this setting a precedent where divisions that do extremely poorly could just be split off from well-performing parts of a firm. Then, other companies owed money by those troubled divisions would just be out of luck. That would create incredible moral hazard for management to allow separate divisions to take as much risk as they like, without needing to worry much about consequences.