While recent reports have suggested three of the most vulnerable monoline bond insurers XL Capital Assurance Inc., CIFG Assurance NA, and Financial Guaranty Insurance Co. are likely to breach statutory levels, the companies say their financial situation is not so dire.

The most recent critique of the financial guaranty companies came from Rob Haines, a senior analyst at research firm CreditSights, who wrote in a report on Monday that the three companies are approaching New York insurance regulators' minimum capital threshold, set at $65 million for the surplus to policyholders.

"Barring a significant capital injection, we think a number of the guarantors could breach statutory capital requirements as soon as the second quarter," Haines wrote. "A breach of the minimum requirement could set into motion a chain of events that could leave the company insolvent."

In the event the companies pierce the capital thresholds, New York State insurance laws dictate that the bond insurers would have 90 days to rectify the impairment. Dropping below capital thresholds could trigger the termination of some or all of the credit default swaps written by the monolines, which could cause the bond insurers to be unable to pay the obligations.

If a company could not rectify its impairment, or was deemed insolvent, regulators would likely come in and take over. They would then begin the process of paying policyholders, and whether policyholders would be repaid at market value or another level would be up to regulators.

"Once it goes into liquidation, the liquidation bureau would look at all the creditors and it would be up to them to decide the payout sequence," said a spokesman for the state insurance department. "We look to treat all policyholders fairly, all claims will be evaluated."

However, both Security Capital Assurance Ltd., the parent of XLCA, and CIFG said Haines' analysis is an oversimplification of their capital levels and does not take into account the structure of how the bond insurers are capitalized. The companies believe they have more time before they would be at risk of tripping the regulatory thresholds.

As an example of the complexity involved in the structures, SCA's $102 million threshold does not include the company's reinsurance arrangements. It is a point conceded by Haines in his report, but further explained by the company.

"To state that the regulatory capital needs to be maintained at this cushion of $102 million doesn't take into account the full picture of the credit support," said Frank Constantinople, group managing director and head of investor relations at SCA. "There are multiple sources of reinsurance."

According to XLCA's structure, XL Capital Assurance has a reinsurance arrangement with XL Financial Assurance Ltd., a reinsurer also owned by SCA. The agreement makes XLFA responsible for reimbursing XLCA for a portion of the actual credit impairments it might take on CDS contracts or the losses on other insurance policies tied to direct residential mortgage-backed securities.

For those policies written in the time since SCA's August 2006 initial public offering, XLFA will reimburse XLCA for 75% of any losses it takes, according to Constantinople. If the transaction was completed prior to the offering, XLFA will reimburse XLCA for 90% of the losses. XLFA currently has about $823 million of capital in excess of insurance regulated thresholds in Bermuda, where it is based that it can use to reimburse XLCA if needed, Constantinople said.

Hypothetically, SCA would have to take losses or impairments of about $1 billion on deals written prior to the IPO to use up the $102 million in surplus capital, or about $400 million in losses on deals written after the IPO. These losses have not occurred.

In addition, SCA says that XLFA benefits from a $500 million stop-loss provision from XL Insurance Ltd., which provides the liquidity with which XLFA would pay a portion of the losses suffered by XLCA, and an XLI guarantee on all of the pre-IPO reinsurance obligations for XLFA. To date, about $50 million of that stop-loss has been drawn down.

The capital funding structure for CIFG and its parent, CIFG Holding Ltd., was less clear. According to Haines' analysis, the company has a capital cushion of just $15 million over the regulators' threshold, and may have already breached the minimum. Moody's Investors Service mentioned similar concerns in its rating report that accompanied the downgrade of CIFG to Ba2 from A1 on May 20.

"CIFG is implementing strategic alternatives for its problematic credits which will significantly improve the company's regulatory capital position," said Michael Ballinger, a spokesman for the bond insurer.

FGIC, the third bond insurer mentioned by Haines with a capital cushion of $301 million declined to comment about its position.

In other news, a U.S. District Court judge on Tuesday, ruled against SCA and in favor of Merrill Lynch International in a lawsuit relating to seven CDS contracts. Merrill had sued XL Capital to abide by $3.1 billion of guarantees written on collateralized-debt obligations, after SCA had terminated the contracts under the allegation that Merrill Lynch had inappropriately transferred the rights over the contracts to a third party.

At the end of the first quarter, SCA had set aside $428.9 million in reserves to cover the losses on these contracts.

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