Wall Street's Next Worry

The subprime carnage could spread to bond insurance firms

By Matthew Goldstein

An exotic form of bond insurance could be the next hidden hazard to blow up in the global credit minefield. An obscure company called ACA Capital (ACA ) might spark the explosion.

The carnage on Wall Street has already been brutal. On Oct. 30, Merrill Lynch (MER ) ousted CEO Stanley O'Neal after the bank took an $8.4 billion hit, largely from securities backed by risky home loans. The same day, UBS (UBS ) cut earnings by $3.6 billion. Citigroup (C ), which has suffered its own $1.6 billion wound, may face a fresh billion-dollar disaster.

Now the crisis is spreading from Wall Street—which has taken $35 billion in subprime-related write-downs and lost more than $220 billion in stock value—to a less well known corner of the financial world, that of the bond insurers. These firms sell insurance to banks and other major investors for bonds backed by mortgages and the complicated investments that hold the bonds, known as collateralized debt obligations (CDOs). The policies are designed to protect investors in case the securities default. As CDOs grew into a trillion-dollar business, bond policies (called credit default swaps) became a lucrative source of revenue for companies such as American International Group (AIG ), MBIA (MBI ), and Ambac Financial Group (ABK ).


But a flurry of downgrades on mortgage-backed securities and CDOs has started to affect insurers' earnings. Anxiety has focused on ACA Capital, a small player with big exposure to CDOs.

A New York company with less than $500 million in annual revenue, ACA has just $326 million in capital for potential payouts if the CDOs it insures go bad. Yet it has sold coverage worth nearly $16 billion, with most policies written for CDOs created in the past couple of years. Those are especially problematic vintages because lending standards grew so lax in 2006 and 2007.

Troubled ACA shareholders have pushed the stock price down 80% since the start of the year, to $3.46. "The worry is that they are going to get hit with all these losses and will have difficulty making good [given the low level of reserves]," says Sean Egan of Egan-Jones Rating.

In an e-mail, ACA says its "financial strength and capital adequacy are at the strongest level in history. That was recognized the other day when Standard & Poor's confirmed ACA's single-A rating and Stable Outlook, acknowledging that ACA has sufficient capital to withstand losses and higher capital charges on our subprime related exposures."

But many believe the subprime debacle has yet to run its course. "There was a perception that the worst was over," says Timothy M. Ghriskey, a co-founder of the $250 million Solaris Asset Management in Bedford Hills, N.Y. "But there's no question this is going to go on for a while."

MBIA, the world's largest bond insurer, with nearly $3 billion in revenues, is at the center of the growing mess. In late October the Armonk (N.Y.) firm announced a $36.6 million loss for the third quarter. MBIA blamed markdowns on CDOs and similar securities, which forced it to cut the value of policies it wrote on those products. MBIA pointed out that the value of those assets could bounce back.

Meanwhile, MBIA and its rivals may have to set aside more capital to cover potential losses from CDOs or risk a possible downgrade on their own corporate debt. On Oct. 29, S&P, which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP ), announced that it is "reviewing new data in order to test the bond insurers' ability to withstand further subprime stress," although so far S&P sees no need for more capital.

Others are more skeptical. Kathleen Shanley, an analyst at bond research service Gimme Credit, says it's likely that MBIA will need to raise capital to keep its AAA rating, given the insurer's position "on the front lines of the credit crunch." MBIA's stock has fallen 23% since early September, which could make it more costly to raise money.

In an e-mail, MBIA says it "has a very healthy capital position and does not foresee the need to raise capital. The company also believes that if the need arises, it will be able to raise capital."

It's difficult to assess the extent of the danger. Bond insurers argue that the worst-case scenario—mass CDO defaults, forcing tens of billions in insurance payouts—is highly remote, given the limited downgrades to date. Insurers also note that many of their policies provide coverage for the highest-rated slices of CDOs, which are the least likely to default.

But those are exactly the CDO segments that have spooked Wall Street. Many banks haven't been able to sell the securities, which are low-yielding and difficult to value. This situation prompted the writedowns by Merrill and others when the value of the investments collapsed.

Insurance issues may have contributed to Merrill's enormous loss. AIG was once one of the biggest CDO insurers, selling some $79 billion in coverage to Merrill, UBS, and other banks. But AIG left the business in 2005, around the time subprime lending standards began to deteriorate. When that happened, says a person familiar with Merrill's insurance, the firm had difficulty finding coverage for the new CDOs on its balance sheet. With little insurance, Merrill felt most of the pain when it marked down the securities. Merrill declined to comment.

AIG's pullback provided ACA with an opportunity to expand its insurance business. The prospect of the tiny insurer now failing to live up to its promises could affect a wide range of banks—and get scary. Banks that bought its policies would have to take the risk from CDO assets back on their balance sheets, prompting further writedowns.

ACA won't reveal its clients, but one is Bear Stearns (BSC ), one of the biggest underwriters of CDOs and home of the two subprime-related hedge funds that imploded this summer. Bear and ACA have close ties. In 2004 the investment bank's private equity arm invested $105 million in ACA, and Bear remains the company's largest shareholder, with some 27% of its stock. ACA Chairman David E. King is a senior managing director at Bear and an executive vice-president of Bear's private equity group.

A recent regulatory filing by Bear reveals that in March and again in May ACA "entered into an insured credit swap" with a Bear affiliate. The precise nature of the deals couldn't be determined, although a person familiar with Bear says its coverage with ACA is "minimal." Depending on various banks' level of reliance on ACA, the insurer's policyholders might now have at least some reason to worry.

Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance

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