* Court already ruled against MBIA in dispute
* MBIA shares at highest level in two months
* BofA shares flat at midday after 26-month low (Adds S&P comment, BofA share activity)
NEW YORK, July 12 Shares in bond insurer MBIA Inc (MBI.N) hit a two-month high on Tuesday after the company dropped a lawsuit against Bank of America (BAC.N), a move investors and analysts said could lead to a larger settlement.
MBIA shares rose 7.9 percent to $9.13 in early afternoon trading. They peaked at one point at $9.45, the highest level since mid-May.
In a court filing on Monday, MBIA said it would drop its lawsuit against Bank of America's Merrill Lynch unit, abandoning claims that Merrill fraudulently misled MBIA into insuring $5.7 billion in risky debt. [ID:nL3E7IC03O]
MBIA's case teetered after a New York appellate court dismissed the lawsuit in February. The company planned to appeal to the state's highest court, but the two sides have agreed to dismiss the case, the filing said.
The dismissal "is likely a precursor to a wider, comprehensive settlement which resolves all outstanding litigation against Bank of America and MBIA," hedge fund manager Manal Mehta of Branch Hill Capital wrote in a note on Tuesday.
There is precedent for such a deal after the bank reached a $1.6 billion settlement in mid-April with MBIA competitor Assured Guaranty (AGO.N).
Standard & Poor's equity analyst Erik Oja said he expects Bank of America to settle its outstanding legal disputes with MBIA. Bank of America shares rose 1 cent to $10.36, though earlier in the session they fell to their lowest level since May 2009.
Any deal likely would end concerns about MBIA's capitalization, the subject of an ongoing legal battle.
New York's top appellate court in late June reinstated a lawsuit by some of the world's biggest banks, claiming that a 2009 restructuring left parts of MBIA undercapitalized. BofA is among the plaintiffs in that case. [ID:nN1E75R0DN]
MBIA was the world's largest bond insurer until the mortgage crisis left it facing massive claims and it lost its "AAA" credit rating. While the company's municipal bond unit still has an investment-grade rating, it is not writing new business while the various legal challenges play out. (Reporting by Ben Berkowitz. Editing by Robert MacMillan)