March 19 (Bloomberg) -- Merrill Lynch & Co. sued XL Capital Assurance Inc. to force the bond insurer to honor $3.1 billion of guarantees on collateralized debt obligations as the securities firm attempts to avoid more writedowns of mortgage-backed debt.

``We filed suit to make clear that XL Capital Assurance Inc. is required to meet its contractual obligations,'' Mark Herr, a spokesman for New York-based Merrill, said in an e-mailed statement today.

CDOs, which repackage mortgage bonds and other assets into new securities, were the biggest source of the more than $195 billion of mortgage-related writedowns and losses reported by the world's largest banks and securities firms since the beginning of last year. Merrill's $24.5 billion top the list. Losses may rise if default protection bought from companies such as XL, a unit of Security Capital Assurance Ltd., fails to pay off.

Merrill, the third-largest U.S. securities firm, fell $5.18, or 11 percent, to $41.45 in New York Stock Exchange trading today, its biggest one-day percentage drop since September 2001. SCA rose 7 cents to 79 cents in over-the-counter trading.

Other bond insurers including MBIA Inc. and Ambac Financial Group Inc. may also seek to cancel $100 billion of contracts on CDOs tied to subprime mortgages that they wrote if they're unable to shore up capital through other means, according to Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance.

``Apparently in light of the current dramatic downturn and deterioration in the credit markets, defendants are having `sellers' remorse,' '' Merrill said in the complaint filed today in Manhattan federal court.

Credit Protection

Hamilton, Bermuda-based SCA, stripped of its AAA bond insurer ratings this year by the three major ratings companies, said last week it was seeking to void the contracts, responsible for $427.4 million of the new reserves for losses set aside last quarter. SCA declined to name the counterparty, which Chief Executive Officer Paul Giordano said on a March 14 conference call failed to meet requirements ``in a fundamental way.''

``We believe that the terminations are appropriate and effective and we expect to defend against any challenge by Merrill,'' Michael Gormley, a spokesman for SCA, said in a telephone interview today.

The debt that Merrill bought protection on from XL last year includes classes of: West Trade Funding II Ltd., Silver Marlin CDO I Ltd., and Jupiter High-Grade CDO VI Ltd. The credit-default swaps offer payments if the securities aren't repaid as expected, in return for regular insurance-like premiums.

Merrill's complaint said that XL this year sought to cancel the contracts by arguing that Merrill isn't ready to exercise the ``voting rights'' as the holder of the insured CDOs classes in ways that reflect XL's written instructions, as agreed upon by Merrill in the contracts.

Controlling Party

The complaint says that XL based the assertion on public information from Standard & Poor's that says Armonk, New York- based competitor MBIA has written protection on classes of the CDOs senior to what XL is providing protection on and is the ``sole controlling party'' for the CDOs.

Merrill responded that it hasn't entered into contracts with another party on the CDOs that would preclude it from acting in the way specified in XL's contracts, according to the complaint.

Jim McCarthy, a spokesman for MBIA, declined to comment about the complaint. Vandana Sharma, a spokeswoman for New York- based Ambac, didn't immediately return a call for comment.

More Lawsuits

Voting takes place among the holders of various classes of CDOs under certain circumstances, such as when a so-called event of default happens. After these events, which can occur when the collateral of a CDO gets downgraded enough to suggest that the most-senior classes won't get repaid, investors can sometimes choose to liquidate holdings or redirect payments from certain classes to others, under varying voting rules.

``Whether or not this case gets tested in the courts remains to be seen,'' said Joe Messineo, a partner at Link Global Solutions, a New York-based structured-finance consulting and recruiting firm. ``However, what is fairly certain is that more suits will follow in increasing numbers.''

Messineo is a former co-head of fixed-income at Cohen & Co., a Philadelphia-based firm that manages and underwrites CDOs.

Merrill owns protection from bond insurers on $19.9 billion of asset-backed CDOs, which it's carrying on its balance sheet at $3.5 billion, according to the company's fourth-quarter report. Merrill wrote down the protection by $2.6 billion in the period to reflect the increasing risk of some bond insurers.

If banks decide to view bond insurers' creditworthiness as non-investment-grade, additions to reserves against default protection on mortgage CDOs written by them may total $26 billion, Standard & Poor's said in a March 13 report. They've risen $12 billion so far, according to the ratings firm.

Merrill Shares

Trading in contracts granting the right to sell Merrill shares for $30 through the market's close on April 18 surged to 115 times the daily average this year. The price of those contracts, known as puts, more than doubled to $2.55.

Merrill's implied volatility, a measure of how much investors are paying to insure against further stock-price losses, rose to 130.06, the highest since at least September 2000, according to Bloomberg data. The increase indicates expectations of bigger swings in the stock's price.

The case is Merrill v. XL, 08-cv-2893, U.S. District Court, Southern District of New York (Manhattan).

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

Last Updated: March 19, 2008 18:11 EDT