Today I closed my short position in MBIA’s January ‘09 call options with a strike price of $10 for 85 cents compared to my selling price of $4. I also closed a short position in the January ‘09 calls with a strike price of $15 for 35 cents compared to my $3.30 selling price. As I previously outlined, the bond insurers are going to be hit by an avalanche of claims and insurers like MBIA have under reserved. After a spectacular rally in August that took MBIA’s share price from $4 to $19, the market has come to accept my view as the stock has collapsed to as low as $5 last week.

However, last night CNBC was reporting a rumor that the Treasury was considering including the monoline insurers among the financial institutions that it wanted to recapitalize. At this point in time no official is confirming this rumor, but given that the lack of confidence in the insurance provided by the monolines is one of the main reasons municipalities are having trouble raising money, I think it’s quite likely that the government will do everything in its powers help keep firms like MBIA solvent.

A government purchase of preferred shares, if done at the same terms as was put forth to the major banks, would be very favorable to MBIA shareholders. The capital would help the company pay out its claims and the 5% interest rate is very cheap. And most importantly, the government backing would mean that there would be no further ratings downgrades. The government would get warrants equal to 15% of the value of the preferreds, which would dilute existing shareholders only modestly.

It is sad that the government is considering a bailout of a company that reaped enormous profits for many years at the expense of taking on a huge amount of risk without firing the management, wiping out the shareholders, and giving the creditors control of whatever is left of the company after the government is paid back. However, without a bankruptcy filing the government has no legal authority to takeover the company and if it waited for a bankruptcy, problems would worsen in the municipal bond market.

So I decided to take profits in my short position before the government steps in and the market reacts favorably, as it started to do late Thursday.