Financial Security Assurance (FSA) is projecting $51.5 million in losses, net of reinsurance, due to insuring the triple-A tranches on seven 1998/1999 vintage arbitrage cashflow high yield CBOs. The monoline is taking a step back from wrapping CDOs to evaluate its criteria and its existing portfolio, but will likely be back in the CDO market in the fall, said sources familiar with the situation.

FSA recently remodeled its $74 billion par amount of CDO exposure and came up with the $51 million estimated loss figure that resulted in a $31 million expense to build up general reserves for estimated losses. Further, FSA took a $16 million charge to recognize a market value decline in a single-name credit default swap transaction where the surety had taken the first loss position in a pool of 100 corporate credits. The firm terminated the swap for a fee of $43 million. The swap is the only first loss position in the FSA's CDO portfolio.

CDO bankers said that FSA is not alone in having to increase reserves against estimated CDO insurance transaction losses. "You can expect to see fewer wraps on CDOs, and the secondary market wraps conduits were using to hedge their existing CDO positions will also become more scarce," said one banker. Triple-A primary CDO spreads have recently ballooned out to 48 to 60 basis points over Libor partly due to conduits having a more difficult time sourcing monoline wraps on new issue senior/subordinate deals, added the source.

FSA's $74 billion in CDO exposures has the following shadow ratings: 48% super senior credit default swap positions triple-A, 27% triple-A, 15% double-A, 3% triple-B, and less than 2% other. Broken down by type, FSA has underwritten $54 billion in senior tranches of synthetic CDOs, $15 billion in high yield CBOs, and $4.6 billion in CLOs.

On the other hand...

Despite publicly stating its intention to take a step back from the CDO market, FSA is apparently providing credit protection on top of an upcoming XLCA CDO wrap.

In the $693 million Gemini Funding arbitrage cashflow CLO that is mostly backed by a pool of middle market loans originated by Industrial Bank of Japan, some investors who want a natural triple-A underlying rating are adding an FSA wrap on top of the XLCA wrap to get it. XLCA is taking the collateral risk of the deal's double-A quality pool and is wrapping it up to triple-A, but if the investor stopped there they would still have a pool with an underlying shadow rating of double-A. By bringing FSA in to wrap the XLCA payment risk, the underlying risk of the CDO investment becomes triple-A, which some investors may require (or may not have been approved yet to take XLCA risk).

Approximately 80% ($547.7 million) of the Gemini Funding pool is a "base portfolio" of mediocre performing middle market loans underwriter that Goldman Sachs has purchased from IBJ Trust Co. at a discount, sources said. An additional pool consisting of $117.9 million of clean leveraged bank loans with an average dollar price of $99.75 is being added to bring up the diversity and credit quality. GSC Partners is managing the clean pool of loans. The senior notes are seen at 60 to 65 basis points over the three-month Libor for an XLCA wrap only.

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