SCA Defends XL’s Terminating Merrill Lynch Guarantee Contracts

Security Capital Assurance Ltd. said Thursday it severed seven credit guarantee contracts with a Merrill Lynch & Co. Inc. unit because the investment bank had given key rights promised to SCA under the contracts to at least one other party.

SCA said its XL Capital Assurance unit was promised control rights on the $3.1 billion of portfolios it had guaranteed for Merrill Lynch International, but Merrill Lynch had given those same rights to one or more third parties.

“The decision to terminate the Merrill Lynch International contracts was not made lightly,” SCA said in a statement.

By terminating the contract, SCA is hoping to get out from under an obligation that could cost it hundreds of millions of dollars.

But ending the contract could also force Merrill Lynch to write down billions of dollars of exposure, which is why the investment bank is suing XL Capital Assurance to get the insurer to make good on the agreement.

“Apparently in light of the current dramatic downturn and deterioration in the credit markets, (the) defendants are having ‘sellers’ remorse,” Merrill Lynch said in the complaint, which was filed this week in the U.S. District Court for the southern district of New York.

Control rights allow the seller of credit default protection to liquidate the portfolio if asset performance weakens. Those rights are crucial for minimizing losses on credit default swaps that require payouts.

The issue of bond insurers terminating contracts is thorny for the $45 trillion credit derivatives market, where investors, banks, and others transfer credit risk.

Most parties post collateral for their credit derivatives trades, but bond insurers do not, and if the insurers do not make good on their obligations, banks that traded with them could lose billions of dollars.

SCA, which guarantees about $165 billion of debt, is struggling now after guaranteeing risky subprime mortgage bonds and other securities whose expected losses are much higher than previously forecast.

It has suspended writing new business to preserve capital. Its main bond insurance unit has lost the top credit ratings crucial for winning new business.

The company is working with Rothschild and Goldman Sachs at strategic alternatives. It posted a fourth-quarter loss of $1.2 billion.

SCA took $632.3 million of charges in 2007 relating to the seven contracts, of which more than $427.4 million represented reserves for actual expected losses.

“If they can get out from under these deals, it will be an enormous relief for this company,” said David Havens, an insurance credit analyst at UBS. (Reporting by Dan Wilchins; Additional reporting by Walden Siew; Editing by Brian Moss)