Moody's Investors Service knocked CIFG Guaranty's financial strength rating further into junk territory yesterday, saying "significant deterioration" in the bond insurer's book since January could force the company into a distressed exchange.

Moody's cut its rating on the New York-based insurer to Caa2 from Ba3 and said it will continue to review it for possible downgrade.

In its second-quarter filing with regulators on Wednesday, CIFG reported its liabilities exceeded assets by nearly $300 million.

The New York Insurance Department requires bond insurers to maintain policyholders' surplus, or assets in excess of liabilities, of at least $65 million.

Moody's attributed the decay to bad credit in the company's book of policies, especially policies covering bonds secured by mortgage loans.

Residential mortgage-backed securities and collateralized debt obligations compose more than 70% of CIFG's insured book, and the ongoing erosion of mortgage credit quality threatens the company's capital, Moody's said.

Because CIFG is well shy of the regulatory minimum for policyholders' surplus, Moody's thinks the chances regulators will intervene have gone up.

Plus, with the prospect of claims outrunning the money CIFG has to pay them, Moody's sees a greater chance the company will pay more insured bondholders to strip their debt of insurance.

Moody's might look at that as a distressed exchange.

In January, CIFG reached deals to commute approximately $12 billion in previously insured structured finance deals, and to have Assured Guaranty Corp. reinsure $13 billion of its U.S. public finance portfolio.

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