XL Capital Assurance Inc. on Thursday explained its decision to cancel seven credit default swaps with Merrill Lynch & Co., saying the bank reneged on its obligations.
The explanation came a day after Merrill Lynch brought suit against XL Capital, alleging that in canceling seven credit default swaps between the two parties the bond insurer was attempting to avoid its financial obligations.
The disagreement centers around seven CDS contracts used by XL Capital Assurance, owned by Security Capital Assurance Ltd., to insure collateralized debt obligations with Merrill Lynch International worth a total of $3.1 billion. Bond insurers often use CDS to provide insurance on CDO transactions.
XL Capital canceled those contracts on Feb. 22, asserting that Merrill turned its back on its contractual obligations written into the contracts. XL alleges that Merrill had given away the controlling rights for the CDOs, according to a release filed by SCA Thursday.
For evidence, XL Capital referred to Standard & Poor's data that shows MBIA Insurance Corp. provided credit protection on the most senior tranches of the same CDOs and represented itself as the "sole controlling party," according to the court documents filed in the suit.
Voting rights and control of CDOs is an important condition of the contract because they can be used to govern what happens to the collateral underpinning the securities. As the financial guarantors assume the risk of the transactions by guaranteeing them, the voting rights and the decision of what to do with the collateral are an integral part of mitigating their risk.
"It was important to [XL Capital] under these agreements that it secured control rights in order to better protect our interests and it is indefensible that Merrill Lynch International chose to strip [XL Capital] of those protections," SCA said in its release.
Under the suit, Merrill alleges that XL's cancellation of the CDS contracts are actually the bond insurer's having "sellers' remorse" in light of falling values on CDOs and the serious credit crunch affecting the markets. Merrill said in the lawsuit, filed with the U.S. District Court in New York, that it has "not engaged in any conduct permitting defendants to repudiate their contractual undertakings."
XL Capital expects that if the cancellation of the CDS is allowed it will free up $417.3 million in capital reserves, as well as reverse $215 million in non-cash and unrealized mark-to-market losses on its baance sheet.
The lawsuit is not the first attempt by bond insurers to free up capital by holding counterparties accountable. Financial Guaranty Insurance Co. and a U.K. subsidiary filed suit March 10 against a German bank, IKB Deutsche Industriebank AG, that was a counterparty for a number of CDS.
FGIC alleged through "the provision of false and misleading information," the bank convinced it to take on the risk of billions of potential losses on an off-balance-sheet special investment vehicle, according to court documents. FGIC is seeking to cancel the potential liabilities of nearly $1.9 billion.
So far, the two suits are the only ones currently being brought by financial guarantors against counterparties. However, if one or both are ultimately found in favor of the bond insurers, more of the monolines may follow.
