Dow Jones Newswires is reporting that Aurelius Capital Master Ltd., Aurelius Capital Partners and funds owned by Fir Tree Partners have a class action lawsuit to prevent the splitting of MBIA (MBI) into separate subsidiaries insuring government and structured product debt. The MBIA plan, endorsed by New York State's Insurance Superintendent Eric Dinallo, would capitalize the new government insurer with $5.4B in cash and transfer all existing MBIA municipal policies. At the same time Reuters is reporting that 15 financial institutions are meeting with Dinallo today to complain that split would adversely affect CDS they wrote on securities wrapped by MBIA.

The complaint alleges the split would deplete capital and income from municipal bond insurance from backing structured products, “leaving some $241 billion of policyholders stranded in a denuded insurer that will be unable to meet its obligations as they come due." Further, certain mortgage backed securities wrapped by MBIA have "tumbled in value by approximately 40%," since the split was announced.

To my knowledge MBIA never insured the value of any security and never committed to post collateral on structured products. But, the government’s actions to make AIG’s (AIG) counterparties whole have empowered investors insured by MBIA to extend their reach. The argument that the split reduces the value of the insurance they purchased and subsequently the value of the underlying structured products has little merit since most banks have already written down the value of the wraps to zero anyway.

The case for a reduced ability to pay claims might have merit, but the negative effect on related CDS written by third parties only comes into play with public policy. The Federal Reserve and the Treasury have placed great emphasis on the system risks inherent in CDS. However, this is a public policy directive and should not add to the obligations of the bond insurers.

The counter and more important public policy need is for restoring an efficient municipal bond market that insurance from Ambac (ABK) and MBIA (MBI) would provide. Only these two companies have the operational infrastructure to support the small issuers that Warren Buffett would not.

Good public policy should never insure the value of any security, only the payment of obligations. But even government policy that virtually guarantees the payment of financial institution debt at the expense of common shareholders actually promotes systemic risk. Holman W. Jenkins, Jr.’s opinion piece in The Wall Street Journal “Buffett's Unmentionable Bank Solution” states:

“Yet the truth is, you get little or no moral hazard bang from punishing bank shareholders. Equity investors, by definition, accept the risk of losing 100% of their stake in return for unlimited upside. Go ahead and wipe out shareholders: Markets will turn around and create the next 50-to-1 leveraged financial institution as long as the potential return outweighs the risk.

The only real fix for moral hazard, in some future regulatory arrangement, would be truly to dispel the belief of bondholders and uninsured creditors that they will be bailed out.”

In summary, MBIA should not be held responsible for third parties losing confidence in its insurance or any related consequences of that lack of confidence. Seeking protection for a drop in value of CDS not written by MBIA is certainly is a far stretch.

Disclosures: Author is long ABK, AIG and MBI.