Recent comments from Ambac Financial and MBIA Inc. suggest that the two largest bond insurers may be warming up to the idea of separating their municipal bond businesses from their more troubled structured-finance units.
"There will be a lot of bumps in the road to that outcome," Light explained. "There will be a lot of disappointed counterparties that had what they thought were guarantees on structured debt deals. Some will almost certainly file suits. Not many will want to contribute any capital to the bad insurer
First -- if this happens I would expect a legal maelstrom almost immediately. The CDO parties will argue their respective insurance policies are based on the companies before a split and therefor the court should not allow the companies to break-up. I would think the insurers would argue the current situation was completely unforeseeable when the parties signed the respective contracts. At least, that's what I would argue (It's amazing I still remember Contracts II). At bare minimum, I would expect an immediate request for an injunction preventing the split until after the situation is worked out.
Second, even if there is an injunction, I think the mere threat of an actual break-up will send ripples through the market that will cost a ton of pain.
Third, if this goes through, the CDO market will take a mammoth hit -- a hit larger than any we have seen so far. One of the prime reasons so many people own these bonds is the insurance, which increased the credit rating on a particular security. A material change in the insurer might lower the credit rating on some deals to below investment grade, forcing a liquidation. That would be damn ugly indeed.