Merrill, XL to Bail Out Bond Insurer Security Capital

By and | July 29, 2008

Merrill Lynch has agreed to help bail out bond insurer Security Capital Assurance Ltd. by canceling $3.5 billion in credit default swaps and ending litigation.

Under the pact, Security Capital will be released from the derivatives guarantees it sold to Merrill. In return it will make a $500 million payment to the investment bank.

The agreement is part of a series of moves by the third biggest U.S. investment bank to reduce risk. The brokerage also said that it planned to issue $8.5 billion of common stock.

As part of the bailout, brokered by New York State Insurance Superintendent Eric Dinallo, Bermuda-based reinsurer XL Capital Ltd. will pay $1.78 billion in cash and issue 8 million shares to Security Capital, a former subsidiary.

XL said it will sell $2.5 billion of securities to help fund the agreement [see related article], which it said will eliminate more than 98 percent of its exposure to Security Capital.

XL spun off Security Capital more than two years ago in an initial public offering that left it with a 46 percent stake, and as a guarantor of some of the risks SCA held before its IPO.

“SCA is going from essentially on the brink of insolvency to a surplus of about $1 billion,” Dinallo said on a conference call with journalists. “It gives us some light at the end of the tunnel that even an extremely distressed bond insurer … can be brought out of a pretty dire situation.”

Bond insurers have been battered by their exposure to complex mortgages and other debt.

Several have lost the pristine “triple-A” credit ratings that many issuers and investors demand, leading Warren Buffett’s Berkshire Hathaway Inc. to fill the void by establishing its own bond insurer.

Security Capital stopped writing new business earlier this year after posting a fourth-quarter loss of $1.2 billion. It had been in litigation with Merrill over credit derivatives it had sold to the Wall Street investment bank and brokerage.

“Given the current market conditions, we think this agreement is in the best interests of our shareholders,” Merrill spokesman Bill Halldin said.

Analysts have questioned whether all parties to credit derivatives are capable of making good on them. That has been especially true for bond insurers, among the few sellers of credit protection not required to provide collateral.

In after-hours trading, XL shares fell $1.64 to $16.73.

“It is hugely costly to XL but it is a move they had to make — their back was against the wall,” said Rob Haines, an analyst at CreditSights Inc. “Their franchise was coming under pressure in that its peer group was stopping doing business with it.”

XL executives, on a call with investors, said they did feel an “urgency” to act before the company’s reputation was badly tarnished by the problems at SCA. Some clients had stopped doing business with the company, XL said, but it expected the issue would ease once it raised capital and capped its SCA liabilities.

However, Haines said XL still faced problems, with a riskier investment strategy from holding more hedge-fund and real estate-backed securities than many rivals at a time when insurance rates are declining.

Chief Executive Mike McGavick, who took over XL’s top job about three months ago, told investors that as part of a wide review of the company he may make changes to its investment business but had not yet made any decisions.

XL said it would take a third-quarter charge of $1.4 billion to $1.5 billion for the Security Capital agreement, and it halved its quarterly dividend to 19 cents per share.

“We have delivered on the commitment to put the SCA overhang firmly behind us,” Chief Executive Mike McGavick said in a statement.

In a call with investors, McGavick said XL was seeking to raise enough capital to be “comfortable” and prevent it from having to be back for more.

Dinallo said the settlement would leave Security Capital “capitalized to our satisfaction.” He said he was aiming for Security Capital to obtain high investment-grade ratings from major credit rating agencies, and that “anywhere in the single-A or double-A range would be an extremely good outcome.”

XL also intends to review “strategic alternatives” for its life reinsurance business, said McGavick, and will put in place measures to cut $70 million in costs annually and boost savings. It will eliminate the chief operating officer post after Henry Keeling, who had held the job, retires on Aug. 1.

Separately, XL Capital said quarterly profit fell 57 percent to $237.9 million. Profit per share fell to $1.34 from $3.00. Excluding items, profit was $1.50 per share, compared with the average analyst forecast for $1.91, according to Reuters Estimates.

Dinallo said he estimated in January that the bond insurance industry would need $10 billion to $15 billion of capital infusions. “That prediction looks pretty good” now, he said.

(Additional reporting by Lilla Zuill; Editing by Andre Grenon, Leslie Gevirtz, Ted Kerr, Gary Hill)

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