Feb. 19 (Bloomberg) -- Credit ratings on more than $580 billion of asset-backed securities may be cut, sparking writedowns by banks, under New York regulator Eric Dinallo's plan to break up bond insurers.

New York Insurance Department superintendent Dinallo proposed splitting the companies' municipal insurance units from their unprofitable businesses of guaranteeing debt linked to subprime mortgages. A separation may preserve AAA rankings for securities sold by local governments and agencies, while allowing asset-backed securities to slide.

``This is one of the worst possible outcomes for the market,'' Gregory Peters, head of credit strategy at Morgan Stanley in New York, said in a telephone interview. Lower ratings would force banks that own the mortgage-backed debt to write down the value of the securities by as much as $35 billion, he estimated.

FGIC Corp., the third-largest bond insurer, sought permission to split last week. Dinallo said MBIA Inc. and Ambac Financial Group Inc., the market leaders, may do the same if they can't raise capital. The companies and Security Capital Assurance Ltd. insure about $1 trillion of municipal debt and $580 billion of other securities, including collateralized debt obligations that package bonds into new securities.

MBIA, based in Armonk, New York, Ambac in New York, and New York-based FGIC are struggling after more than $8 billion in losses tied to the slumping value of subprime debt.

New CEO

MBIA today said it brought back former Chief Executive Officer Joseph Brown to run the company and expedite talks with regulators to help preserve its AAA credit rating. Gary Dunton, who succeeded Brown as CEO in 2004 and added the title of chairman last year, will leave the company.

``MBIA faces meaningful challenges,'' Brown said in a statement. Brown said he is seeking to ``frame a new model,'' for MBIA, which has tumbled 82 percent the past 12 months in New York Stock Exchange trading. FGIC is owned by New York-based leveraged buyout firm Blackstone Group LP and mortgage insurer PMI Group Inc. of Walnut Creek, California.

Ambac may seek to raise at least $2 billion by selling discounted shares to stockholders before considering a breakup in which one unit would insure municipal bonds and another would cover riskier debt, the Wall Street Journal reported today, citing unidentified people familiar with the situation.

Trading Losses, Writedowns

Citigroup Inc., Merrill Lynch & Co. and more than 20 other banks and securities firms are reeling from $146 billion in trading losses and writedowns from the collapse of the subprime mortgage market. They may have to record $70 billion of additional costs if the insurers fail, Oppenheimer & Co. analyst Meredith Whitney wrote in a report last month from New York. The companies bought bond insurance to hedge the risks of CDOs.

``It strikes me as unexpected for the market and I don't know how that can be good,'' said Bruce Bonjour, a partner at Perkins Coie LLP in Chicago and chairman of the law firm's financial transactions committee. ``How are investors going to have confidence when somehow regulators can come along and reconstitute what you've invested in?''

The plan may trigger ``years of litigation,'' according to Bank of America Corp. analysts.

``Despite the regulatory interest in separating the exposures, the essential fact remains that all policy holders, whether municipal or structured finance, entered into contracts backed by the entire entity,'' Bank of America analysts led by Jeffrey Rosenberg in New York wrote in a Feb. 15 note to investors. A breakup is ``likely to lead to significant legal challenges,'' the note said.

Buffett Offer

Dinallo, 45, proposed the plan after billionaire investor Warren Buffett offered last week to take over $800 billion of municipal debt guaranteed by MBIA, Ambac and FGIC for more than $9 billion. The regulator tried to organize a bank plan to inject capital into FGIC and Ambac. His office oversees MBIA. Ambac, while based in New York, is primarily regulated by Wisconsin.

The companies probably need about $5 billion and a line of credit for $10 billion, Dinallo said in an interview with Bloomberg television. Sovereign wealth funds, LBO firms and other investors are interested in participating, he said.

Dinallo is prepared to give preference to municipalities over holders of CDOs or other asset-backed securities.

``Certainly it is something we are looking at, to not necessarily treat all sides of the book exactly the same,'' he said in the interview on Feb. 15

Moody's cut FGIC's insurance rating to A3 from Aaa last week and said the company was about $4 billion short of the capital needed for the highest rankings. MBIA raised $2.5 billion including a sale of $800 million of shares to Warburg Pincus LLC. Ambac sought back up insurance to reduce its capital needs.

MBIA Chief Financial Officer Chuck Chaplin and Ambac Chief Executive Officer Michael Callen told the House Financial Services Committee last week they don't need a bailout or added oversight.

To contact the reporters on this story: Mark Pittman in New York at mpittman@bloomberg.net; Christine Richard in Washington at crichard5@bloomberg.net

Last Updated: February 19, 2008 09:19 EST