Imagine, for a moment, what a court might say if state regulators allowed an insurance company, facing huge losses because of Hurricane Sandy, to separate itself into two companies. One, thinly capitalized and in clear danger of not being able to pay all claims, would insure the areas hit by the hurricane, like the beach towns of New Jersey and the Rockaway area of Queens. The other, with plenty of capital, would carry all the policies that were not likely to have large claims.

Of course, no regulator would do that. And any court confronted with such an act would search for reasons to overturn it.

Now imagine an insurance company split up with the clear purpose of discriminating against a set of policyholders who were the subject of overwhelming public scorn rather than public sympathy — perhaps the people who had caused the catastrophe that led to the losses.

Just such a case was decided this week. And the state regulator’s decision was upheld by a judge who concluded that the regulator was entitled to the widest possible latitude in making its decisions. If the regulator had not bothered to verify calculations in the insurance company’s financial projections, and those calculations turned out to be wildly inaccurate, that was fine with the judge.

That case did not concern a hurricane, of course. It instead concerned the financial storm that sent the world into recession and led countries to bail out the banks that had made bad loans that led to the disaster.

The insurance company was MBIA, a company that prospered insuring municipal bonds, almost all of which were safe anyway. It then made the huge mistake of deciding to also insure structured financial products, like collateralized debt obligations and commercial mortgage-backed securities. It did little investigation of what actually backed those securities, explaining later that its low fees made such investigations too expensive. Instead it relied on the ratings agencies and on the banks that had put the securities together.

That reliance was misplaced, and MBIA is now in danger of being unable to pay claims on those securities.

In 2009, with the blessing of its regulator, the New York State Insurance Department, MBIA decided to split in two. On one side, fully protected, were the insurance policies issued to muni bond investors in the United States. On the other side were the structured finance policies, which would mostly benefit the banks that had bought such products. A group of banks sued to overturn the breakup.

Justice Barbara R. Kapnick of the New York State Supreme Court — a trial court despite the lofty title — listened to lawyers argue for 13 days over whether the case should proceed to trial. She decided there was no reason for a trial. The insurance department had wide latitude to approve the split with or without much investigation, and she would not second-guess it.

Anyone from the Securities and Exchange Commission who might read Justice Kapnick’s opinion will be envious. The S.E.C. has to contend with a court — the United States Court of Appeals for the District of Columbia Circuit — that instinctively throws up roadblocks to any rule the commission passes. The S.E.C. jumps through whatever hoops the court established in its last decision but, somehow, it never quite manages to live up to what the D.C. circuit requires in its next ruling.

Justice Kapnick, on the other hand, is not bothered by the fact that the state insurance department relied on MBIA financial filings that turned out to be very inaccurate — not just later but at the time that the filings were made.

The banks, she said, “fail to provide any legal authority to support their argument that this court can annul the department’s decision based on claims that MBIA concealed or withheld potentially damaging information” from the department.

She quotes from a deposition by Michael Moriarty, the deputy superintendent of the department and the man who signed the letter approving the split. When considering MBIA’s request, he said, “the department did not, nor do they usually, verify the financial condition of a company.” Since that was the policy, the judge concluded she had no authority to question it.

The New York Insurance Department has since been combined with the state banking regulator in a new body, called the Department of Financial Services, and that body seems to be very worried about MBIA’s ability to meet its obligations in the structured finance unit.

An interest payment that MBIA owed on a junior security it had sold to investors was not paid in January, because the department would not allow it.

Floyd Norris comments on

finance and the economy at nytimes.com/economix.

Article source: http://www.nytimes.com/2013/03/08/business/court-ruling-against-banks-lets-mbia-benefit-from-splitting-up.html?partner=rss&emc=rss