Merrill files suit against XL CA; shares drop

By Chris Reiter

NEW YORK (Reuters) - Merrill Lynch & Co Inc MER.N said on Wednesday it sued XL Capital Assurance Inc seeking to stop the insurer from backing out of credit guarantees, fueling speculation the world's largest brokerage may need to take further write-downs.

Merrill Lynch's shares fell 11 percent, reflecting the fragility of the investment banking sector after Bear Stearns Cos BSC.N faced a run on the bank and was forced to sell itself for a pittance.

XL Capital Assurance, a unit of Security Capital Assurance Ltd SCA.N, had agreed to protect about $3.1 billion of Merrill's portfolios of consumer debt against default.

The SCA unit used credit default swaps to provide the guarantee, and its efforts to get out of the contracts reflects what could be a widening problem on Wall Street: cash-strapped bond insurers backing out of obligations. That in turn could force banks to choose between two unpalatable options: litigation or writing down the credit derivatives that provided the guarantees.

Credit derivatives have mushroomed into a $45 trillion market in recent years as a way for investors to hedge risk and bet on credit, but some analysts have cast doubt over whether all counterparties in such trades have the capacity to make good on them. That is especially true with regard to bond insurers, which are among the few sellers of credit protection not required to post collateral.

Merrill Lynch said in January that as of the end of 2007, it had about $3.45 billion of exposure to bond insurers for portfolios of asset-backed securities.

"You never want to see litigation headlines cross on a company. That just adds fuel to the fire," said Peter Lobravico, vice president of risk arbitrage sales/trading at Wall Street Access. "

He said speculation about a big write-down at Merrill, which has been swirling for a couple days, picked up steam on Wednesday.

Joe Saluzzi, co-manager of trading at Themis Trading in Chatham, New Jersey, said there were rumors of a $12 billion write-down and a $6 billion private placement.

"This is all speculation, but the bottom line is that there are write-down rumors at Merrill," said Saluzzi. "Either way, something stinks over there and the way the market has been lately is that people shoot first and ask questions later."

Merrill said it does not comment on market rumors.

Merrill shares fell $5.18 to close at $41.45 on the New York Stock Exchange, making it the top decliner among Wall Street brokerages in a rough day for the sector.

'SELLERS' REMORSE'

Merrill said XL Capital Assurance terminated seven credit default swaps contracts, claiming that Merrill had failed to adhere to obligations in the contracts. Merrill disputes the claim and sought to force the company to honor the contracts.

"Apparently in light of the current dramatic downturn and deterioration in the credit markets, (the) defendants are having 'sellers' remorse," Merrill said in the complaint, which was filed in the U.S. District Court for the southern district of New York.