NYSID causes first monoline CDS default

An auction is to be held to settle credit derivatives linked to Syncora, the monoline formerly known as XL Capital Assurance, after a committee declared a credit event to have occurred on the firm on May 1.

Syncora became the first monoline to enter technical default after an order by the New York State Insurance Department (NYSID) compelled it to stop making payments to counterparties from April 26 until the company brought itself back to financial health.

Like other monolines, the company has tried to restructure its portfolio by settling -or 'commuting' - its most troubled policies on terms agreeable to its financial counterparties.

"It is prudent in the short term not to allow payment of significant claims by an insurer that has reported itself to be insolvent. This period will allow the insurer and its counterparties to continue negotiations without creating preferences in claims payments," NYSID said.

Syncora would be placed in rehabilitation if a restructuring of the beleaguered insurer was not completed soon, it added. A spokesman for the department would not say whether it planned to take similar action for other firms in future.

"What the regulator has done is ask the company to stop making payments right away even if it had the means to do so, so that it still has enough capital for the rest of its policyholders," said Ratul Roy, the New York-based head of collateralised debt obligation (CDO) strategy at Citi.

Based on the order to stop payments, the decision to call a credit event on the firm was unanimous among the 15 dealers and buy-side representatives that voted on the committee.

Many banks continue to have hefty exposures to failing monolines, including Syncora. These have arisen in a variety of ways, including buying or trading monoline-wrapped assets and negative basis trades. Negative basis trades, which were particularly prevalent among European banks, involved buying assets such as subprime mortgage-backed debt and simultaneously buying credit default swap (CDS) protection on them from monolines. This way, the bank earns the spread between the cash assets and CDS, while being theoretically flat credit risk.

However, as the value of monoline-wrapped or insured assets has declined, so too has the creditworthiness of monoline counterparties. This wrong-way risk has destroyed the value of hedges at the very time dealers need them most.

Nonetheless, many banks will have already written down the value of protection bought from Syncora, according to Citi's Roy. "Most prudent institutions will have been taking provisions for their monoline exposures through their counterparty valuation adjustment. I am assuming most people would have written down a lot of the protection they thought they initially had," he said.

Syncora had written protection on a $42.8 billion portfolio of CDOs, Citi figures show. This includes $14 billion of protection on collateralised loan obligations, $14.3 billion on CDOs of asset-backed securities, $5.8 billion on investment-grade corporate CDOs, $4.9 billion on CDOs of commercial mortgage-backed securities and $1.5 billion on CDOs squared.

Other bond insurers - including those to which some banks are much more heavily exposed - are also looking shaky.

In February, MBIA was downgraded to BBB+ by rating agency Standard & Poor's, while competitor Moody's Investors Service slashed it to B3 - a level below investment grade. On April 13, Moody's downgraded Ambac's debt to junk bond status, to Ba3.

On April 20, research firm CreditSights said UBS, Deutsche Bank, Barclays and Royal Bank of Scotland (RBS) were the European banks that would suffer most from further monoline writedowns during 2009.

The Swiss bank held monoline protection with a fair value of $12.33 billion, while the fair value of Deutsche Bank's monoline hedges was €8.3 billion according to the firm. Barclays had hedges in place with monolines worth £10.16 billion on a fair value basis, while the fair value of monoline protection held by RBS was £11.58 billion, CreditSights said.

Such market dynamics are causing an increase in the number of monoline claims disputed in court. On April 30, for example, MBIA announced it would sue Merrill Lynch for misrepresenting the risk of $5.7 billion worth of credit protection it sold to the dealer. The firm claimed it faced expected losses "in excess of several hundred million dollars" on the four CDOs it insured.

See also: Moody's: FGIC unable to meet payments
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Fiscal strain poses challenges for monolines
Ambac and MBIA record heavy Q3 losses
MBIA and Ambac in further ratings review