Nov 29 2007

ACA’s Dificulty Spooking the Fed

Published by Johannes Ernharth at 2:54 pm

Bloomberg published a story on November 21 noting JPMorgan analysts are suggesting that ACA Financial Guarantee Corporation, one of the nations largest bond default insurers of collateralized debt instruments, may be “thrown to the wolves.” This comes after S&P placed its “A” rating of financial strength on “CreditWatch with negative implications” based on a variety of factors on November 9. S&P is the only ratings company that has a rating on ACA.

That downgrade was in response to ACA Capital’s (the parent company ACA FGC) announcement that it had $1.04 billion net losses in the 3rd quarter, compared with earnings of $16.1 million over the same period in 2006. Meanwhile, Pershing Square Capital’s William Ackman yesterday predicted ACA wil go bankrupt.

Now, if a downgrade takes place, counterparties that insured their CDOs with ACA FGC would find themselves with a big problem. Reported the Financial Times on the day of the S&P warning,

Because ACA Financial is rated A – well below the industry norm of AAA – its CDO CDS contracts contain a provision requiring it to post collateral in the event of a downgrade, said the market participant. Such provisions require ACA to post cash equivalent to the mark-to-market loss of the CDS contract pursuant to a ratings cut.

ACA said in a 10-Q filing this week(from Deloitte Touche) that it won’t meet collateral requirements if its rating falls below A-. In other words, ACA FG would become insolvent and default on its insurance agreements, as the FT story points out.

Which brings us back to JPMorgan’s observations noted above. Reported Bloomberg,

ACA is among nine bond insurers being vetted by ratings companies after the value of the CDOs they insure fell. Moody’s Investors Service and Fitch Ratings are examining AAA rated insurers including MBIA Inc., Ambac Financial Group Inc. and FGIC Corp. to see if they have enough capital. A loss of the top ranking by the insurers would throw into doubt ratings on $2.4 trillion of debt.

“ACA is a likely candidate to get thrown to the wolves first,” Wessel said in an interview today. If ACA defaults, banks would then have to bring their ACA-guaranteed CDOs onto their books, said Wessel, who is based in New York and has a neutral rating on the stock.

Most of our readers already know that many of the CDOs out there are backed by home loans, especially those issued in 2005 and 2006 amid the height of the housing bubble and asinine lending recklessness.

That translates into all sorts of problems. Consider what Barron’s had to say on the problem on November 19:

ACA has long been a convenient dumping ground in which major subprime securitizers like Bear Stearns, Citigroup, Merrill Lynch and some 25 other prominent dealers could pitch billions of dollars of risky obligations for modest premiums. That let them gussy up their balance sheets and shift any potential mark-to-market hits to ACA.

If ACA Capital were to founder, more than $69 billion worth of CDOs, including the $25 billion in subprime paper, would come rumbling back to the Wall Street banks, and likely with heavy attendant losses.

That’s why Wall Street has continued to do a brisk business with the beleaguered firm. In the third quarter, ACA insured some $7 billion of subprime collateralized-debt obligations. Even if the company survives for only another couple of quarters, that would stave off the recognition of billions of dollars of losses.

Meanwhile, word on the Street is that Fed officials have been asking around about what everyone means about $60 billion plus getting dumped back onto the balance sheet of banks, which is hardly comforting to those not knee deep in the mess considering the Fed is asking for a very fundamental clarification of the credit system it purports to be managing policy decisions.   Additionally, we hear that MBIA might also be reinsuring some ACA business, which puts MBIAs ratings further in the spotlight.
In any event, the last paragraph quoted in the clip just above is telling.  In other words, this is all part of the “let’s not let any of this toxic waste get a value” charade that Wall Street has been dealing with since mid July when Bear Stearns blew the top off the rumbling credit bubble volcano. And, the fact that Wall Street was relying on an A rated insurer vs. AAA tells you they were walking the edge of the cliff with a wink and a nod. (It reminds me of the IBG-YBG mentality that permeates bubble profit making on Wall Street. IBG YBG is an acronym for “I’ll be Gone, You’ll be Gone”, which would be whispered among investment banking teams when a troubling facts would turn up amid due diligence while creating weak deals these bankers knew would become an minefield of liabilities under the watch of future players. The focus was simply to get the deal done and out the door, and into the year-end bonus column. (John Knee wrote the book “The Accidental Investment Banker” which exposed this mentality in the equally dubious late-90’s bubble.)

But I digress… This possibility pushes the value of many assets held on the book at “guaranteed insured value” into the market place to be valued at market, which places additional pressures on assets already dealing with the prior mark to model (e.g. mark to fantasy) method. Moreover, it is also exposing the fact that much of this insurance written by players like ACA, in the end, is subject to renegotiation under threat of insolvency. MaxedOutMama ask the very pertinent question: What kind of insurance is that?!?

Counterparty risk in the massive derivatives market is a great, big unknown. So many assets have been pledged as collateral for this or that based on the values of guarantees through the derivatives markets, largely which rely on the most basic guarantees of the insurers. Perhaps this is why Warren Buffet used the phrase “Financial weapons of mass destruction” when discussing the rapidly expanding $516 trillion derivatives market, which just expanded 49% YOY to cover $43 trillion of debt with credit default swaps as of June 30, according to the BIS. The bulk, some $347 trillion, are interest rate swaps that insure against interest rate risk. With the massive miscalculation of default risk being exposed in the market place, one can only wonder if equal miscalculations have been made regarding interest rates, and what ensuing monetary policy might be engineered should lenders finally decide to jack up interest rates to compensate for massive dollar losses in recent years and a U.S. economy that appears to be sliding into recession.

Which leads us to news that the housing market is further decelerating:

And it comes as no surprise that we see these sorts of headlines:

In August we said this was just the tip of the iceberg, which is what we also said of the initial turmoil in late December of 2006 and earlier this year, and that’s what we said of the housing slowdown that was first emerging to those paying attention back in late 2005. Today we’ll go as far as to say the vastness of this iceberg is growing quite clear. Now players must come to terms with the reality that we’ve entered a field of them at a reckless pace that assures more than a few additional hits. Hopefully you’re doing more than rearranging the deck chairs on the ship that is taking water as it steams ahead barely aware of the real damage or the problems that lie ahead.

For those interested in a little ACA background:

Shares were are trading earlier today down 94% on the year, at $ 0.85.   Just a year ago in November 2006, the company raised $90 million in a share offering, for which it is now suffering a class action law suit that claims ACA overstated its financial condition. The private-equity investment arm of New York-based Bear Stearns Cos., the fifth-largest U.S. securities firm, also bought a 29 percent stake in ACA in 2004 for about $100 million.  How efficient were those markets?  That’s why they call it the Efficient Market Hypothesis!

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