NEW YORK (Bloomberg) — Bermuda-based CIFG Holding Ltd., the owner of the smallest of the formerly AAA-rated financial guarantors, reached an agreement with banks to tear up contracts guaranteeing the repayment of $12 billion in securities.

The company will give bank counterparties an undisclosed amount of cash and equity, according to a statement yesterday from CIFG.

CIFG said it's seeking to reinsure its public finance portfolio with an AA rated insurer to enhance the protection provided holders of CIFG-insured municipal bonds.

"When we reach final agreement, it will work to the mutual benefit of all parties, as it will restore CIFG to financial health and better position the company to honour its obligations to policyholders," chief executive officer John Pizzarelli said.

The deal to tear up the contracts follows several so-called commutations by other bond insurance companies, including ACA Financial Guaranty Corp. and Bermuda-based Syncora Holdings Ltd. (formerly known as Security Capital Assurance), which have sought to avoid regulatory takeover by cancelling agreements with Wall Street firms that threatened their solvency.

The bond insurer's financial strength rating was cut 11 levels to CCC from A- in May by Fitch Ratings, which said the company was at risk of falling below its minimum regulatory capital requirements. CIFG may pay claims of as much as $3.6 billion on securities backed by sub-prime mortgages and other home loans, Fitch said. The company was downgraded even after French customer-owned banks Caisse d'Epargne and Banque Populaire made a $1.5 billion capital contribution. The banks took control of CIFG Guaranty from their jointly run investment bank, Natixis SA, in December.

When Fitch downgraded CIFG, it said a breach of the company's regulatory capital cushion could trigger mark-to-market payments on $57 billion of credit-default swap contracts. CIFG, like most other bond insurers, used swap contracts rather than bond insurance policies to guarantee the payment on collateralised debt obligations, or CDOs.

"Based on current market valuations, Fitch does not believe CIFG would have sufficient claims-paying resources to meet these obligations, triggering a likely default of its insurance subsidiaries," Fitch analysts Joo-Yung Lee and Thomas Abruzzo wrote in the May report.

CDOs, which repackage assets such as mortgage bonds, buyout loans and derivatives into new securities, have accounted for the biggest slice of the $509 billion in asset write-downs and credit losses since the start of 2007 at the world's banks.