Aug. 8 (Bloomberg) -- ACA Capital Holdings Inc., the bond insurer that lost its investment-grade credit ratings in December, terminated $65 billion in credit-default swap contracts and turned over most of the company to creditors.

Counterparties now own a 95 percent residual interest in New York-based ACA Capital's insurance unit through surplus notes, the company said in a statement today. Howard Seife, a lawyer at Chadbourne & Parke LLP representing 12 counterparties, provided the face value of the canceled credit-default swap contracts.

Bond insurers, seeking to limit claims and improve their capital position, are trying to get out of credit-default swap and other derivatives contracts that they used to guarantee securities linked to now-failing subprime mortgages. Merrill Lynch & Co. in January wrote down $1.9 billion in securities it tried to hedge through ACA, and Canadian Imperial Bank of Commerce had to sell more than C$2.75 billion ($2.6 billion) in stock after taking writedowns tied to ACA.

ACA has no more structured-finance exposure and now only guarantees municipal bonds, the Maryland Insurance Administration said in a statement today. ACA now has enough assets to meet its obligations to municipal-bond policyholders, the state said.

``Given all of the problems faced by monoline insurers today, the resolution we achieved with ACA may well serve as a model for other companies,'' Seife said.

Run-Off

Maryland regulators must sign off on payment of the surplus notes, Seife said. ACA Capital retained 5 percent of the notes.

The insurance unit, ACA Financial, will go into run-off, meaning it will seek to meet its existing obligations and not write additional policies.

H. Russell Fraser, who helped turn Fitch Ratings into one of the three major rating companies, started ACA in 1997 to insure municipal bonds that AAA rated insurers wouldn't cover, including financing for nursing homes and rural hospitals.

After Fraser left the firm in 2001, to run a beef jerky manufacturing company in Wyoming, ACA expanded into the structured finance business, guaranteeing securities mainly through credit-default swap contracts. By the time the company was downgraded late last year, it had insured 10 times more structured-finance securities than municipal bonds.

Credit-default swaps, conceived to protect creditors against default, are used to speculate on creditworthiness or to hedge against losses. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Forbearance

ACA Financial was forced to seek reprieves after Standard & Poor's lowered its credit ratings 12 levels to CCC in December, suggesting potential default. Counterparty agreements required ACA to post collateral if its rating fell below A-.

The unit had reached six forbearance agreements with counterparties since late last year under which banks waived their rights to receive collateral against guarantee contracts, to terminate contracts and to receive claims payments.

The company didn't have the assets to meet those collateral calls and would have been insolvent, Maryland regulators said.

ACA backed about $7 billion of municipal bonds, including $25 million of bonds sold by the Community Academy Public Charter School in Washington, D.C., and $8.2 million of securities sold by Tuskegee, Alabama, according to company disclosures earlier this year. The value of ACA insured municipal bonds, many of which weren't rated on a standalone basis, tumbled, following the collapse of ACA's financial guarantee rating.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or the weather.

To contact the reporter on this story: Christine Richard in New York at crichard5@bloomberg.net

Last Updated: August 8, 2008 16:10 EDT