Sell Side

Fitch Ratings Lowers XLCA to CCC From BB

Fitch Ratings yesterday downgraded XL Capital Assurance Inc. to CCC from BB one day after the bond insurer's parent, Security Capital Assurance Ltd., announced agreements with XL Capital Ltd. and Merrill Lynch & Co., that will enhance its solvency thanks to a capital infusion and the termination of credit default swaps and other policies. Fitch placed the rating on evolving watch.

Fitch based its decision on the announcement XLCA will report negative statutory capital as of June 30 and uncertainty about the execution of the agreements. Fitch said a separate set of "post-settlement" ratings of XLCA and XL Financial Assurance Inc. - the other SCA subsidiary which was also downgraded to CCC - could improve significantly once the deals are closed.

"Any 'post-settlement' ratings assessment of SCA would incorporate not only the improvement in SCA's capital position, but also Fitch's view of various qualitative factors," Fitch said in a statement. "These would include SCA's franchise value and business outlook, which appear to be highly uncertain due to the negative implications from SCA's exposure to mortgage-related credits."

In addition, Standard & Poor's yesterday said that its BBB-minus ratings on XLCA and XLFA remain on negative watch while Moody's Investors Service placed XL Capital Ltd. on review for downgrade.

Following the completion of the agreements - announced by New York insurance superintendent Eric Dinallo late Monday - XLCA will have an expected surplus of $1 billion after approaching the brink of insolvency. The regulatory agency dispatched staffers earlier this month to prepare for the company's rehabilitation when it feared SCA would not meet its deadline for solving its capital shortfall, Dinallo said.

Under the deal, SCA's subsidiaries will receive $1.775 million in cash and eight million in XL Capital Ltd. Class A ordinary shares from XL Capital Ltd. in return for the "termination, elimination, or commutation" of reinsurance and other financial guarantee agreements made between them and XL Capital Ltd. and its subsidiaries. XL Capital Ltd. plans to pay with the $2.5 billion it expects to raise from the sale of stock and hybrid securities.

In addition, XL Capital Ltd. will transfer its remaining 46% ownership in SCA to a trust held for the benefit of XLCA and eventually its financial counterparties, once agreements with them are reached. XLCA will also hold $820 million in cash and other assets for the financial counterparties in expectation of further deals to terminate CDS agreements.

Under its agreement with Merrill, SCA will pay $500 million in return for the commutation of eight credit default swaps backing $3.74 billion. The ongoing litigation on seven of those CDSs will also be dropped.

Both agreements are expected to close in early August.

"This ... is good for all - Main Street and Wall Street, the bond insurance industry and SCA policyholders, municipal bond holders and structured bond counterparties," Dinallo said in a statement.

Fitch said the settlements may qualify as "distressed" under its methodology, meaning the ratings on XLCA and XLFA could fall to "default" status once the deal with Merrill closes. Although Fitch could then upgrade the "post-settlement" ratings of XLCA and XLFA to investment-grade levels, the formality of a "D" would deliver another blow to the beleaguered bond insurance industry, according to Dick Larkin, director of research for Herbert J. Sims & Co.

"This is important because it will represent the first time that a bond insurer did not fully pay out on a claim, and sets a precedent," Larkin wrote. "This action is more than symbolic, and casts more clouds over the worth of guarantees extended by bond insurance companies, further tarnishing the industry's reputation."

However, the potentially high investment-grade rating for the recapitalized company provides a benefit to current bond holders, Dinallo said.

In addition, the agreement serves as a "template" for other distressed insurers by providing a roadmap for unwinding the CDS positions, Dinallo said. Although pricing on CDS commutations will differ given the insurer and its capital position, the deals give at least a base number for what they might be worth.

"I think people are beginning to understand this is not some black hole problem that cannot be solved," Dinallo said in an interview yesterday. "I actually think [Monday's] news was quite large - it's the first time that sophisticated players resolved large relationships in these bond insurers."

Dinallo said the insurance agency is currently in talks with other insurers to form similar agreements to terminate CDS agreements. The current focus is on Financial Guaranty Insurance Co. and CIFG Assurance NA. because they are in "binary" situations - either making a similar deal or forced to enter rehabilitation, Dinallo said. He added that the agency already extended a 30-day deadline it had set for FGIC to develop a capital-raising plan, as the company had made "progress."

The stock prices of many insurers rose in trading yesterday. Shares of SCA rose 61.54% to $0.84 at the close of trading. Shares of Ambac Financial Group Inc and MBIA Inc. also showed double-digit gains, moving to $2.11 and $4.92, respectively. Assured Guaranty Ltd. rose 11.28% to $11.54, and Radian Group Inc. rose 24.52% to $1.93.

But even if other insurers do make deals, it might be a "double-edged sword", according to Rob Haines, analyst for CreditSights. The companies reduce their risk exposure, but only by sending capital to the counterparty cancelling the deal, Haines said. The insurers will also miss out on future installment premiums on the CDSs and will still have difficulties writing any new business.

"You just accelerated kind of a self-fulfilling vicious circle, you really didn't help yourself," Haines said. "It's all dependent upon them getting back to the market, and on SCA's point, they're not going to get back to the market. All this does is allow everyone to feel better for a couple quarters."

Separately, as a result of a prior agreement preventing SCA from using the XL name, XLCA and XLFA will change their names to Syncora Guarantee Inc. and Syncora Guarantee Re Ltd., respectively, effective Aug 4. SCA will change its name to Syncora Holdings Ltd.


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