Merrill, XL to bail out struggling bond insurer

By Jonathan Stempel and Dan Wilchins

NEW YORK (Reuters) - Merrill Lynch & Co MER.N agreed to help bail out bond insurer Security Capital Assurance Ltd SCA.N by cancelling $3.5 billion in credit default swaps and ending litigation in return for $500 million in cash.

The agreement is part of a series of moves by the third biggest U.S. investment bank to reduce risk. The brokerage also said on Monday it planned to issue $8.5 billion of common stock. (For story, click on [nN28182950)

As part of the bailout, brokered by New York State Insurance Superintendent Eric Dinallo, Bermuda-based reinsurer XL Capital Ltd (XL.N) will pay $1.78 billion in cash and issue 8 million shares to Security Capital, a former subsidiary.

XL said it will sell $2.5 billion of securities to help fund the agreement, which it said will eliminate more than 98 percent of its exposure to Security Capital.

"SCA is going from essentially on the brink of insolvency to a surplus of about $1 billion," Dinallo said on a conference call with journalists.

"It gives us some light at the end of the tunnel that even an extremely distressed bond insurer ... can be brought out of a pretty dire situation."

Bond insurers have been battered by their exposure to complex mortgages and other debt.

Several have lost their pristine "triple-A" credit ratings, which many issuers and investors demand, leading Warren Buffett's Berkshire Hathaway Inc (BRKa.N) (BRKb.N) to fill the void by establishing its own bond insurer.

Security Capital stopped writing new business earlier this year after posting a fourth-quarter loss of $1.2 billion. It had been in litigation with Merrill over credit derivatives it had sold to the Wall Street investment bank and brokerage.

"Given the current market conditions, we think this agreement is in the best interests of our shareholders," Merrill spokesman Bill Halldin said.

STILL FACING PROBLEMS

Analysts have questioned whether all parties to credit derivatives are capable of making good on them. That has been especially true for bond insurers, among the few sellers of credit protection not required to provide collateral.

In after-hours trading, XL shares fell $1.87 to $16.50.

"It is hugely costly to XL but it is a move they had to make -- their back was against the wall," said Rob Haines, an analyst at CreditSights Inc.

"Their franchise was coming under pressure in that its peer group was stopping doing business with it."