As if the insurance industry didn’t have enough of an image problem, the bad press generated by the boneheaded acceptance of subprime mortgage exposures by bond insurers has prompted devastating headlines and a new round of questions about whether carriers are adequately regulated–including the inevitable call for Uncle Sam to come to the rescue.

Even though financial guaranty insurance accounts for a tiny portion of overall industry premium, failures of judgment in that sector put all insurers in a terrible light and sent regulators scrambling to battle stations.

Keep in mind the public does not appreciate the distinction between one type of insurer over another. To the average person, insurance is insurance. Thus, the story is that once more, the industry let everyone down.

While disputes over wind-versus-water claims following Hurricane Katrina muddied the industry’s image terribly, in a way the damage done by bond insurers is even worse because the potential impact reverberated nationwide, not just in disaster-prone areas–impacting municipal governments everywhere.

“Like a child with matches, [the bond insurers have] gotten burned. We must hope that they did not ignite our economic house as well,” said Rep. Paul Kanjorski, D-Pa., who chaired a hearing in Washington on the industry’s latest debacle.

Since the subprime mortgage crisis exploded–taking banks, investment bankers, bond insurers and the stock market down with it–lawmakers, both state and federal, have been scrambling for a solution.

In the short term, capital is being raised at a frantic pace, new reinsurance backing is being sought, and efforts are underway to possibly isolate solid municipal bond portfolios from the tainted basket of bad mortgage securities. It appears carriers will hold onto their most valuable asset–their “triple-A” rating–for now.

Long term, however, Congress is getting into the act, prodded by those who insist only federal oversight can protect against additional financial fiascos.

I don’t think that’s an obvious solution at all, and neither does New York Gov. Eliot Spitzer–no stranger to insurance industry shenanigans–who went to Capitol Hill with a strong message to Congress: Butt Out!

“The fact that the states need to improve does not lead to the conclusion that federal regulation of insurance is the answer, especially given the performance of other federal regulators on this issue,” he testified.

“I would note that just creating an agency with the power to act does not guarantee it will in fact act,” he added. “Creating a national regulator will not make a difference if those appointed to run it choose not to use those powers effectively.”

Gov. Spitzer rubbed it in a bit, testifying that “many failures have been caused by the lack of federal regulatory entities to regulate–or worse, to block prudent regulation by others.”

He reminded Congress that “one of the benefits of having 50 state regulators is that it is more likely someone will recognize a problem and act on it.” Gov. Spitzer knows of what he speaks, having led the charge against broker bid-rigging and insurers cooking their books.

He also clashed with Washington over his push to hold nationally-chartered banks accountable for violations of state consumer protection laws. Federal courts rudely gave him a stiff arm on that attempt, thus he is not eager to surrender any state authority over insurers to the feds anytime soon.

What’s next? Will Congress do more than grandstand? That depends, I think, on whether bond insurers can find a way out of this mess, and how soon.