Standard & Poor's Friday downgraded MBIA Inc.'s public finance subsidiary, National Public Finance Guaranty Corp., to A from AA-minus. The outlook is developing.

Standard & Poor's cited its "view of both [National's] uncertain business and capital-raising prospects." National's capital adequacy is "marginally" below Standard & Poor's AA standard, the rating agency said.

"Management's stated goals are to raise additional capital to bolster National's current resources and effectively ring-fence National from MBIA and its more volatile book of business," Standard & Poor's analyst David Veno said in a statement. "However, the ring-fencing actions it has taken so far have had limited impact in that we view National as no more or less ring-fenced than any typical bond insurance subsidiary operating in a consolidated group."

MBIA Inc. in February announced it had split the public finance and structured finance books of MBIA Insurance Corp. National received the responsibility for the public finance book and about $5 billion.

The restructuring has since come under legal challenges from structured finance policyholders and surplus noteholders, who say they have been hurt as the result of a fraudulent transfer that benefits public finance policyholders at their expense. Standard & Poor's noted these lawsuits serve as an "impediment to both business prospects and capital-raising efforts."

The outcome of the lawsuits could have an impact on National's future ratings, the agency said. The rating could be raised if the lawsuits are resolved favorably, which could "facilitate capital-raising efforts and lead to more tangible separation of National from MBIA and MBIA Inc."

"Improving business acceptance could be an outgrowth of these developments, which could lead to a rating in the AA category," Standard & Poor's said. "Alternatively, an ongoing lack of market acceptance and continued weak financial flexibility could result in a downgrade to the BBB category."

In response, National said it viewed the downgrade as a "temporary setback". It said it is a "strong, well capitalized investment grade company."

"We remain committed to the U.S. public finance market and plan to raise additional capital for National as soon as circumstances reasonably allow, with the goal of achieving the highest possible ratings over time to meet the municipal market's demonstrable need for credit enhancement," National chief executive officer Tom McLoughlin said. "National will vigorously contest the litigation that S&P references in its decision and is moving to dismiss the lawsuits as we believe they are baseless and directly challenge the approvals of the New York State Insurance Department."

Standard & Poor's also downgraded MBIA Insurance Corp. to BBB from BBB-plus and MBIA Inc. to BB from BB-plus. The outlook for both is negative.

Standard & Poor's downgraded MBIA Insurance on increased loss assumptions on 2005 to 2007 vintage direct residential mortgage-backed securities and collateralized debt obligations of asset-backed securities. The agency also noted it believed that MBIA will not be able to fully realize the benefits of its tax-loss carryforwards.

MBIA executives had said during their first-quarter conference call in May that although the lawsuits are "completely without merit," they would have some effect on the company's marketing in the short term.
The company has also discussed raising outside capital, but said that National was capitalized at a "very high level" under Standard & Poor's and Moody's Investors Service's existing models.

The rating downgrade should not come as a surprise, according to Municipal Market Advisors managing director Matt Fabian. No matter what steps are taken to separate it, a bond insurance subsidiary will always have some "linkage" to the rest of the company, he said.

The downgrade will create more challenges as National attempts to restart new business production.

"They were already facing very long odds to relaunch that business," Fabian said. "It's hard to understand why management would continue to pursue this. It makes it very difficult for them to credibly project much new business with these ratings."

Elsewhere, both MBIA and the financial counterparties suing it filed documents asking for orders to show cause in their case yesterday. Each asks the other party in the lawsuit to show why what they are requesting should be ordered.

The lawyers for the financial counterparties want the judge to force MBIA to turnover documents they have requested and to set a timeline so that the trial can begin Dec. 15. MBIA wants the judge to issue an order for a stay of all discovery pending a ruling on the motion to dismiss it plans to file.

A hearing will be held June 10.

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