NEW YORK (Bloomberg) — Regulators' plans to break up bond insurers into "good" businesses covering municipal debt and "bad" businesses liable to subprime-related losses may trigger "years of litigation," Bank of America Corp. analysts said.

New York Insurance Department Superintendent Eric Dinallo and New York Governor Eliot Spitzer said last week that insurers may need to be divided if they can't raise enough capital to compensate for losses on subprime-mortgage guarantees. FGIC Corp., the fourth-largest of the so-called monoline insurers, asked to be split on February 15 after Moody's Investors Service cut the Stamford, Connecticut-based company's top Aaa ranking.

"It is the equivalent of going to a casino and trying to keep only the winning bets," said Tim Mercer, chief investment officer at Hong Kong-based hedge fund Musashi Capital Ltd. "This would be a straightforward case of fraudulent conveyance and everyone involved would be liable for damages from deprived creditors." FGIC, owned by Blackstone Group LP and PMI Group Inc., insures about $314 billion of debt, including $220 billion in municipal bonds. The company said last week it applied for a licence from New York state insurance regulators to create a stand-alone municipal company and separate the unit that guarantees sub-prime-mortgage bonds and related securities that led to rating downgrades.

New York-based Ambac Financial Group Inc., the second- largest bond insurer, may also seek a split, the Wall Street Journal reported yesterday, citing a person familiar with the situation.

"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," analysts led by Jeffrey Rosenberg in New York wrote in a note to investors last week. A break-up is "likely to lead to significant legal challenges holding up the resolution of the monoline issues for years".

Investors in credit-default swaps based on the bond insurers may also seek damages to compensate for losses, according to the research note. Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.

The cost of credit-default swaps on Armonk, New York-based MBIA Inc., the world's largest bond insurer, has soared to $1.7 million upfront and $500,000 a year to protect $10 million of bonds from default for five years, according to CMA Datavision. The contracts, which cost $25,000 a year ago, trade upfront when investors see a risk of imminent default.

Any break-up of the companies may cause "significant widening" in the credit-default swaps as the structured finance company is likely to be "deeply distressed," the Bank of America report said.

"The authorities' encouragement of such a solution reveals their fundamental misunderstanding of basic commercial law and principles and also their sense of desperation," said Musashi Capital's Mercer.