Monolines - the nuclear option

XL Capital Assurance and Financial Guaranty Insurance Company (FGIC) face legal action by three banks after cancelling insurance contracts they had written on asset-backed securities transactions.

The lawsuits have raised further doubts over the future of monoline insurers, and come on the back of multibillion-dollar writedowns on their structured finance portfolios, downgrades and the erosion of their capital base.

Merrill Lynch filed a suit with the southern district court in New York against XL Capital Assurance (XLCA), the financial guarantee subsidiary of Security Capital Assurance (SCA), on March 19. The filing claims XLCA cancelled seven credit default swaps contracts worth $3.1 billion in an attempt to avoid payouts.

“Merrill Lynch is confident that the credit default swaps are fully enforceable,” said Merrill Lynch in a statement. “The complaint seeks a court order that each of the credit default swaps remains in full force and effect.”

SCA disputes the claims, arguing that Merrill Lynch violated the terms of the contract by committing to provide one or more third parties with the same collateralised debt obligation (CDO) control rights that it had previously promised XLCA. As such, it was justified in cancelling the guarantees, it said.

“The decision to terminate the Merrill Lynch contracts was not made lightly. It was important to XLCA under these agreements that it secured control rights in order to better protect our interests and it is indefensible that Merrill Lynch chose to strip XLCA of those protections,” the company said in a statement on March 20.

For the year ended December 31, 2007, the company recorded a writedown of $623.3 million relating to those credit default swap contracts, of which $215 million represented a net unrealised mark-to-market loss and $417.3 million represented reserves for losses.

Separately, FGIC is embroiled in disputes with both Düsseldorf-based IKB Deutsche Industriebank and Calyon over guarantees written on a CDO in June 2007. The disagreement centres on a special purpose vehicle (SPV) called Havenrock II. The guarantees covered $1.875 billion in high-rated tranches of CDOs of asset-backed securities, out of the SPV’s total portfolio of $2.5 billion. The disputed contracts account for 75% of FGIC’s $1.71 billion loss reserves committed by the company in its end-of-year results.

On March 12, FGIC filed a lawsuit against IKB, its asset manager Calyon, and the SPV over the financial stability of IKB, which has been bailed out four times since July – the first time on July 30 after KfW Bankengruppe, a 38% shareholder in the bank, assumed IKB’s obligations under a liquidity facility for its Rhineland Funding conduit.

FGIC claims that “through a series of fraudulent misrepresentations and omissions regarding IKB’s financial condition and stability, FGIC was induced to enter into the commitment agreement”, according to a note added to the company’s end-of-year results on March 25. Calyon has responded by filing a lawsuit at the Royal Courts of Justice in the UK seeking to enforce the guarantees.

Both monoline insurers were downgraded on March 26 by Fitch Ratings. XLCA was downgraded from AA to BBB, while XLCA was reduced from A to BB. In its rating notice of XLCA’s parent, SCA, Fitch noted that a “ruling in SCA’s favour [in the Merrill Lynch lawsuit] could have a meaningful positive impact on the company’s capital position and credit ratings in the future”. That’s because the disputed contracts account for a major portion of estimated losses from the rating agency.

“What is happening is that technicalities are being sought for these troubled exposures. Where they would likely have to pay off soon, the insurers may be able to cancel the policy and avoid paying out,” comments Robert Haines, insurance analyst at research firm CreditSights in New York. “The question is, are they grasping at straws to try to desperately avert any further meltdown?”

See also: Crisis point
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Dragged down