The dwindling coalition of banks challenging the New York State Insurance Department's approval of MBIA's 2009 restructuring have been insisting for years that MBIA hoodwinked state regulators, who were all too eager to restore stability to municipal bond markets. Then-Superintendent Eric Dinallo, the banks assert, didn't adequately investigate MBIA's $5 billion spin-off of its municipal bond business and segregation of its deeply troubled structured finance insurance portfolio. Instead, they claim, he caved to political pressure and approved the restructuring after only a cursory evaluation of MBIA's overly rosy projections about its ability to pay claims by structured finance policyholders.

There's plenty of evidence to refute those assertions in newly-released filings by MBIA and the N.Y. Department of Financial Services (which includes the former Insurance Department). In redacted responses to the bank coalition, MBIA and state regulators detail the back-and-forth they engaged in as regulators tried to figure out how to balance the rights of MBIA structured-finance policyholders and the need to stabilize the muni bond market, presumably with the help of money from the federal government. In an affidavit from Dinallo, who is now a partner at Debevoise & Plimpton, the former superintendent said he designated the most experienced evaluator in his department, Jack Buchmiller, to run a careful review of MBIA's proposed restructuring.

The banks have alleged that Buchmiller was the lone vetter, and Dinallo relied much too heavily on his judgment. Dinallo's affidavit said, however, that Buchmiller worked alongside other Insurance Department lawyers and investigators. And in his own affidavit, Buchmiller justified his expertise. "I had substantial prior experience in creating and reviewing a variety of financial models and projections, including during my 22 years of experience in commercial banking, derivatives, and securities prior to joining the Department," he wrote. "Moreover, I had experience with loss reserve modeling at the Department as a result of my participation in several financial examinations of [financial guaranty insurers] (including MBIA Corp.) and other projects for the Department before my review of the transformation."

Fair enough. But state regulators conceded that they didn't create their own models for MBIA's post-transformation accounting. Nor did they reconstruct MBIA's modeling of post-restructuring accounting. Instead, Buchmiller evaluated MBIA's modeling, which he found to be "reasonable, consistently applied, and consistent with best practices in the financial guaranty insurance industry."

As it turns out, however, MBIA's submission to the regulators was not entirely accurate, according to the new filings by MBIA and state regulators.

The errors in MBIA's presentation are detailed in an affidavit from MBIA CFO Chuck Chaplin, who said the mistakes had been discovered as MBIA prepared its defense against the banks' allegations. The biggest error, according to both Chaplin and state regulators, involved MBIA's miscalculation of its potential tax benefits in certain worst-case hypotheticals. According to the state, that mistake would have resulted in MBIA's 2009 surplus to policyholders, in the hypothetical extreme-stress scenario, evaporating into a loss of $291 million.

MBIA also erroneously modeled expected-loss projections, which, according to Chaplin, resulted in an understatement of "the projected near-term cash flow in the 'stress' and 'extreme stress' scenarios" MBIA presented to state regulators. In addition, MBIA made errors, Chaplin said, in certain reinsurance assumptions, contingency reserve assumptions, and accounting for asset-swap investment income.

MBIA told state regulators evaluating the deal that in hypothetical models, it projected that it could withstand the stress of $3.2 billion in losses following its restructuring, while still maintaining the statutory surplus New York insurance law requires. But according to the Chaplin affidavit, that number should have been "over $2 billion," not $3.2 billion.

MBIA and state regulators point out that the errors all involved accounting models for purely hypothetical future scenarios, not MBIA's actual ability to pay structured-finance claims. (MBIA has repeatedly noted that it has paid every claim that's been made since the 2009 restructuring.) Both Buchmiller and Dinallo said in the newly-released filings that MBIA's split would have been approved even if MBIA hadn't submitted erroneous models.

"MBIA Corp. had substantial contingency reserves of over $1.3 billion -- more than four times the amount necessary to cover the hypothetical shortfall in the surplus to policyholders in the 'extreme stress' scenario," the state brief said. Buchmiller added: "Had these errors been corrected at the time of my review, it would not have led me to change my conclusion regarding MBIA Corp.'s post transformation solvency, for at least two reasons. First, the treatment of the deferred tax asset was a technical issue not reflecting upon the actual value of the asset, but merely the timing of when it could be recognized. Second, and more importantly, I was aware that MBIA Corp. had substantial contingency reserves of over $1.3 billion, a portion of which the Department would have allowed MBIA Corp. to release in order to restore its surplus during the period of this hypothetical shortfall."

Trial in the regulatory case is set to begin on April 3. I guess we'll find out then if MBIA's erroneous submissions are a game-changer or a red herring.

(Reporting By Alison Frankel)