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The House Financial Services Committee hearings held February 14 enlightened me to the real purpose of the monoline bond insurers in the municipal market. The insurance aspect is actually subordinate to the monolines' role as a less costly alternative to rating each individual municipal issue. The bond insurers commoditize municipal bonds in a very positive way.

All participants agreed that the actual default rate in the municipal market is extremely low. Ambac (ABK) and MBIA (NYSE:MBI) stressed that they have the infrastructure to evaluate and monitor individual issues far more economically than the ratings agencies. New York Governor Spitzer, NY Insurance Superintendent Dinallo, two crying mayors, and the monolines all concurred that only the largest issues and issuing agencies could be economically rated by Fitch, Moody's and S&P.

All parties in the hearing (except Bill Ackman) also agreed that the monolines were in no danger of defaulting on their obligations to pay claims. Ackman (currently shorting ABK and MBI) raised the concern that after paying CDO claims, no money would be left to pay municipal bond claims.

Spitzer and Dinallo seemed to be only concerned with the monolines retaining a triple-A rating. When asked why no action was taken earlier, both claimed they had no regulatory authority over insurance company ratings. They could only bring an insurer into "rehabilitation" when there is a risk of the insurer not being able pay claims.

Yet Spitzer (bad cop) has been threatening to do so in every media outlet available to him. Dinallo (good cop) has been much more subtle, trying to convince the monolines that it is in their interest to cooperate and either maintain their triple-A rating (if possible) or split their book.

The first monoline to start the splitting process was FGIC. It is unclear how the capital will be divided. The New York Times' "A Split-Up of Insurers of Bonds Is Considered" says that most of the capital would go to the CDO (bad book) side and the municipal (good book) side would raise new capital from banks. The Financial Times and Wall Street Journal were not clear on the capital allocations. FGIC will try to solicit new municipal business from the good side of the house, but it is unclear whether the ratings agencies will view both sides of the same house separately.

The banks holding insured CDOs are not sitting still. They have their lawyers working this weekend to protect the value of the insurance they purchased. The banks might challenge the legality of any split.

Any solution the New York regulators try to impose must provide for a viable bond insurance industry going forward. Putting these companies in run-off would be disastrous for our crying mayors. No other insurers have the infrastructure and systems to handle new issues from small and medium issuers. Governor Spitzer appears to be sacrificing the future for near term liquidity.

Obviously, Buffett is not currently equipped to handle small towns and school districts. That's why his approach is reinsurance.

Coming up next (from the House of Representatives website): "House Financial Services Committee Chairman Barney Frank today announced that the committee will hold a hearing on March 5, 2008, at 9:30 a.m. to examine the impact on state and local governments and other municipal authorities as the current credit crisis worsens."

Disclosure: The author is long ABK and MBI.

Source: More Than Just Insurance: Monolines Provide an Efficient Municipal Market