The credit crunch passed another milestone yesterday as Merrill Lynch became the first known investor to sue a bond insurer, claiming that Security Capital Assurance was attempting to avoid meeting claims on $3.1 billion (£1.6 billion) of souring bonds.

Bond insurers guarantee interest and principal payments on securities they underwrite in the event of default.

The Merrill Lynch case is expected to be the first of many disputes between mortgage bond investors, such as investment banks and hedge funds, and their insurers as rising defaults on the securities’ underlying home loans lead to a surge in insurance claims.

The lawsuit raised fears that bond insurers will not be able to meet all the claims that they are expected to receive. These fears have helped to depress prices on many of the bonds they underwrite, and attempts by insurers to avoid claims will push them down farther. This could cause further billion-dollar writedowns by investment banks and other bondholders on their mortgage securities portfolios.

Shares in Merrill Lynch closed down $5.18, or 11.1 per cent, at $41.45 amid fears that the bank might bear the brunt of losses relating to the bonds insured by Security Capital.

Chris Whalen, of Institutional Risk Analytics, said: “This is the first time I have seen a dealer and a counterparty going at it like this in court, but we are going to see a lot more of this. The insurers will argue that the market is now so ambiguous that the claims don’t fit the event.”

Security Capital said: “We believe that the terminations are appropriate and effective and we expect to defend against any challenge by Merrill.”

Merrill Lynch said: “We filed suit to make clear that XL Capital Assurance \ is required to meet its contractual obligations for credit default swaps [insurance policies] it agreed to.”

— It has emerged that a fixed-income hedge fund run by JWM Partners, the investment firm headed by John Meriwether, the founder of Long Term Capital Management (LTCM), lost 24 per cent of its value between January 1 and March 14. The fund suffered as increasing margin calls by nervous creditors forced hedge funds such as Peloton to unload assets. JWM opened a year after Russia’s 1998 default resulted in almost $4 billion of losses for LTCM, Mr Meriwether’s previous hedge fund.

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