Merrill and XL to bail out struggling bond insurer

By Jonathan Stempel and Dan Wilchins

NEW YORK (Reuters) - Merrill Lynch MER.N agreed to help bail out bond insurer Security Capital Assurance SCA.N by cancelling $3.5 billion (1.8 billion pounds) in credit default swaps and ending litigation.

Under the pact, Security Capital will be released from the derivatives guarantees it sold to Merrill. In return it will make a $500 million payment to the investment bank.

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.

As part of the bailout, brokered by New York State Insurance Superintendent Eric Dinallo, Bermuda-based reinsurer XL Capital(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.

XL spun off Security Capital more than two years ago in an initial public offering that left it with a 46 percent stake, and as a guarantor of some of the risks SCA held before its

IPO.

"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.