Two mortgage insurance giants that plan to merge — MGIC Investment Corp. and The Radian Group Inc. — say they could lose their entire $1 billion investment in a subsidiary, C-BASS LLC, that’s heavily invested in credit risk of subprime mortgages.

The news prompted Fitch Ratings to downgrade the senior debt rating of MGIC Investment Corp. from A+ to A, and the insurer’s financial strength of subsidiaries Mortgage Guaranty Insurance Corp. and MGIC Australia Pty Ltd. from AA+ to AA.

Fitch said the downgrades reflect the reduced financial and earnings strength of the company that would result from its potential C-BASS losses.

“That said, MGIC continues to maintain a leading market position in the mortgage insurance industry and a strong capital base more than capable of absorbing risk at an ‘AA’ IFS rating level,” Fitch analysts said in a press release.

MGIC claims its subsidiary Mortgage Guaranty Insurance Corp. is the leading U.S. provider of private mortgage insurance coverage, with $186.1 billion primary insurance in force covering 1.3 million mortgages as of June 30.

Fitch analysts also placed the ‘A’ long-term debt ratings of The Radian Group Inc. and the ‘AA’ insurer financial strength ratings of all of its mortgage and financial guaranty subsidiaries on Rating Watch Negative for potential downgrade.

The Rating Watch Negative for Radian “reflects that company’s relatively weakened stand-alone financial position as a result of C-BASS,” Fitch analysts said.

MGIC Investment and Radian announced in February that they would merge. Fitch analysts said turbulence in the mortgage markets coupled with the potential losses at C-BASS have, at a minimum, “slightly increased the probability that the merger may not go forward as planned.”

If the merger does not go through, Fitch said its ratings for Radian and its insurance subsidiaries would be downgraded by one notch.

In its last quarterly report, MGIC warned that C-BASS was “particularly exposed to funding risk and to credit risk through ownership of the higher-risk classes of mortgage-backed securities (MBS) from its own securitizations and those of other issuers.”

Because 80 percent of C-BASS’s financing has a term of less than one year, the company is vulnerable to margin calls if investors lose confidence that the homes that serve as collateral for loans won’t cover losses on those loans.

“While C-BASS’s policies governing the management of capital at risk are intended to provide sufficient liquidity to cover an instantaneous and substantial decline in value, such policies cannot guaranty that all liquidity required will in fact be available,” MGIC warned.

Fitch analysts said that in the last 10 days, MGIC and Radian have provided C-BASS with a $50 million unsecured credit facility, but that both companies have stated that their entire combined investment of $1.034 billion in C-BASS is at risk.

C-BASS issued a statement today saying it is also looking for cash from other investors as it struggles to meet margin calls from investors, which totaled $260 million in the first 24 days of July.

“We believe that nothing justifies this substantial amount of margin calls received in such a short period of time, particularly as there has been no change in the underlying fundamentals of our portfolio,” the company said.

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