Feb. 14 (Bloomberg) -- Bond insurers may be split into two businesses in what would be the biggest overhaul of the industry since it was created almost four decades ago.

New York Insurance Department Superintendent Eric Dinallo said such a separation is one of the proposals regulators have been discussing with bond insurers, including MBIA Inc. and Ambac Financial Group Inc.

``One would have the municipal bond policies and any other healthy parts of the business,'' Dinallo said in prepared testimony for a hearing today of the House Financial Services subcommittee on capital markets in Washington. ``The other would have the structured finance and problem parts of the business.''

New York Governor Eliot Spitzer told the committee that the step, while ``not optimal,'' may be necessary if the companies can't raise the capital needed to stave off credit-rating downgrades. The world's largest bond insurers may lose the AAA ratings they use to guarantee $2.4 trillion of municipal and mortgage-backed debt, casting doubt on the rankings of thousands of schools, hospitals and local governments around the country.

Dinallo said his main goal is to protect the municipal borrowers and debt holders. Executives of Armonk, New York-based MBIA and Ambac are also scheduled to appear before the committee and will say they can survive the slump in mortgage securities.

Recapitalization

The best option is to recapitalize the bond insurers and stabilize the companies without dividing them, Spitzer told reporters after his testimony. ``That could happen within a couple of days,'' he said.

Dinallo last month organized banks to begin plans for a rescue of the insurers and said he may consider tightening restrictions on what bond insurers can guarantee.

Splitting the companies in two was proposed by billionaire investor Warren Buffett, who this week said he offered to take over $800 billion of the municipal debt guaranteed by MBIA, Ambac and FGIC Corp., the fourth-largest bond insurer. The plan would leave behind the guarantees on mortgage-backed securities and other corporate debt responsible for the companies' losses.

Spitzer told the committee that such a ``good bank, bad bank structure,'' may be necessary if other rescue plans fail. Federal regulation may also be needed, he said.

``I am not opposed to federal regulation but how and when it is done needs to be thought through,'' Spitzer said in an interview with Bloomberg Television.

Insurers are supervised by states rather than the federal government, with New York often taking a lead role. New York regulates bond insurers under Article 69 of the state insurance law, Spitzer said in his testimony, calling the statute ``the standard for state insurance departments around the country.''

Policy Options

U.S. lawmakers at the hearing today criticized the practices of the bond-insurance industry, saying they turned good debt bad and need to be put under the supervision of a federal regulator.

The expansion by the industry beyond their traditional municipal-bond businesses to guaranteeing debt linked to riskier subprime mortgages and home-equity loans, ``has had disastrous consequences,'' Spencer Bachus of Alabama, the top Republican on the House Financial Services Committee, said.

Representative Paul Kanjorski of Pennsylvania, who is presiding over the hearing today, proposed enacting a law that would allow the Federal Home Loan Banks ``to enhance municipal bonds with letters of credit like Fannie Mae and Freddie Mac already do.''

Spitzer said that would be a ``very worthy idea.''

``Other policy options include imposing new requirements for credit rating agencies and addressing the differences between ratings on structured finance products, corporate debt and municipal bonds,'' Kanjorski said.

Approaching Buffett

Dinallo said he approached Buffett to value the municipal bond portfolio of the three largest insurers.

``There may be other investors who would be interested in investing in the municipal side of the business,'' Dinallo said in his testimony.

MBIA and New York-based Ambac, the two largest bond insurers are reeling from their expansion beyond guaranteeing municipal debt to collateralized debt obligations, which repackage assets such as mortgage bonds and buyout loans into new securities with varying risk. As the value of some CDOs plummets, ratings companies are pressing insurers to add more capital.

MBIA rose 98 cents to $12.62 today in New York Stock Exchange composite trading. Ambac climbed $1.16 to $10.53. MBIA and Ambac tumbled more than 80 percent in the past year as they posted record losses of more than $5 billion and concern grew the companies may not get enough capital to sustain their ratings.

No Bailout Needed

MBIA Chief Financial Officer Charles Chaplin dismissed suggestions that the industry needs a rescue or stronger federal oversight, according to his prepared remarks.

``A bailout of highly credit-worthy companies who, at most, are at risk of losing the very highest ratings available, is misplaced,'' Chaplin said.

MBIA has raised $2.6 billion through investors and an additional $500 million in capital has been generated as existing policies have run off and through gains in the investment portfolio, Chaplin said in an interview ahead of his scheduled testimony before the hearing.

``That gives us a cushion of more than a $1 billion to each of the rating agency's stated requirements,'' Chaplin said. ``No reasonable person would say MBIA won't be able to pay claims.''

Chaplin and Ambac Chief Executive Officer Michael Callen are trying to fend off critics who say the companies may be headed for bankruptcy. One of the most vocal skeptics, hedge fund manager William Ackman, will also deliver remarks today.

Municipal Focus

Spitzer told the committee that the economy may face a ``financial tsunami'' as a result of potential downgrades to bond insurers and a tightening of credit markets that resulted from bad loans to homebuyers.

Federal regulators blocked earlier efforts to tighten rules, and the Office of the Comptroller of the Currency allowed ``the problem to grow and the bubble to inflate,'' Spitzer said.

Spitzer and Dinallo both said their focus is on the municipal market rather than banks and financial institutions that sought insurance on structured-finance securities.

``We cannot allow the millions of individual Americans who invested in what was a low-risk investment lose money because of subprime excesses,'' Dinallo said. ``Nor should subprime problems cause taxpayers to unnecessarily pay more to borrow for essential capital projects.''

Demand for AAA rated securities still exceeds the supply and New York has invited new companies to provide bond insurance, Dinallo said.

``It has become clear that the loss of the AAA rating essentially cripples the company's ability to do business as a going concern,'' Dinallo's testimony said.

FGIC Corp., the bond insurer owned by Blackstone Group LP and PMI Group Inc., lost its Aaa insurance rating at Moody's Investors Service today after failing to raise enough capital to compensate for losses on subprime-mortgage guarantees.

To contact the reporter on this story: Christine Richard in Washington at crichard5@bloomberg.net; James Tyson in Washington at jtyson@bloomberg.net

Last Updated: February 14, 2008 16:14 EST