ACA Customers Allow More Time to Unwind Default Swaps
By Mark Pittman and Cecile Gutscher
Jan. 21 (Bloomberg) -- ACA Capital Holdings Inc., the bond insurer being run by regulators after subprime-mortgage losses, won a month's grace to unwind $60 billion of credit-default swap contracts that it can't pay.
ACA, under the control of the Maryland Insurance Administration, extended an agreement that waives collateral requirements, policy claims and termination rights until Feb. 19, the New York-based company said in a statement on Business Wire late yesterday.
The insurer said it's working with trading partners ``to develop a permanent solution to stabilize its capital position'' after losses of $1.04 billion in the third quarter.
Standard & Poor's cut ACA's rating 12 levels to CCC last month, casting doubt on the company's guarantees and triggering collateral requirements. ACA, which lost 97 percent of its market value in the past 12 months, caused Merrill Lynch & Co. to write down $1.9 billion of securities last week and Canadian Imperial Bank of Commerce to sell more than C$2.75 billion ($2.7 billion) in stock to cover writedowns.
Bond insurers' shares plunged last week and credit-default swaps rose to a record on concern the companies may be unable to meet their obligations as the subprime-mortgage securities and collateralized debt obligations they guarantee slump in value.
Ambac Financial Group Inc., the second-largest bond insurer, had its AAA credit ranking cut to AA by Fitch Ratings. Both Ambac and its larger rival, MBIA Inc., are under threat of losing the top grades from Moody's Investors Service and S&P, a move that would throw doubt on the ratings of $2.4 trillion of securities.
An after-hours call to ACA last night by Bloomberg News wasn't immediately returned.
``ACA is an important case to follow because it shows how the banks' react to fast-deteriorating counterparty creditworthiness,'' said Toby Nangle, who helps oversee $37 billion as head of global aggregate business at Baring Asset Management in London.
The bond insurers, also known as monolines, guaranteed $127 billion of CDOs backed by subprime-mortgage securities as of June 30, according to S&P. CDOs are created by packaging debt or derivatives into new securities with varying ratings.
Most of those guarantees are in the form of derivatives. Unlike insurance, these contracts are required to be valued at market rates. Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.
ACA was founded in 1997 by former Fitch executive H. Russell Fraser, who left the ratings company in 2001 as it shifted focus to structured finance from municipal bonds.
Fraser said his idea was to start an A-rated municipal bond insurance company to guarantee a new crop of borrowers he sometimes called ``the cream of the crap.'' ACA's larger competitors such as Ambac and MBIA had enough cash to get the top AAA ratings on their insured bonds.
ACA backed $51.5 million of bonds sold to finance the construction of a jail in Pinal County, Arizona, and $4.7 million of bonds for the city of Deadwood, South Dakota.
CDOs were created by Wall Street by repackaging assets such as mortgage bonds and buyout loans into new obligations for sale to institutional investors. The insurers agreed to pay CDO holders, many of them banks that created the securities, in the event of a default.
The tipping point came last year when the three major rating companies downgraded thousands of CDOs. Ratings on more than 2,000 CDOs were cut in November alone, according to a Dec. 13 UBS AG research report.
Maryland Insurance Administration held off filing delinquency proceedings last month while ACA sought capital. ACA was required under its credit-default swap contracts to post collateral if its rating fell below A-.
ACA gained 2 cents, or 4 percent, to 48 cents in over-the- counter trading on Jan. 18 in New York.
``The monolines are dead, their business model is dead,'' said David Roche, head of investment consultancy Independent Strategy in London. ``The government is going to have to recapitalize this industry or there will be communities in the U.S. where they can't even flush their toilets'' because they can't afford the services.
Prices for contracts that pay investors if Armonk, New York-based MBIA can't meet its debt obligations imply a 71 percent chance the company will default in the next five years, according to a JPMorgan Chase & Co. valuation model. Contracts on New York-based Ambac imply a 72 percent probability.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. 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. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.
New York State Insurance Superintendent Eric Dinallo is examining whether to limit the types of debt that can be guaranteed by bond insurers, department spokesman David Neustadt said last week.
The Federal Reserve may need to organize a bailout, Nangle at Barings said. ``More generalized monoline meltdown would be a situation that would require intervention by the New York Fed,'' said Nangle. The regulator should ``get all the banks into a room, have them open their books, and then lean on them to inject capital.''
-- With reporting by John Glover in London. Editors: Emma Moody, Gavin Serkin
To contact the reporter on this story: Mark Pittman in New York at email@example.com Last Updated: January 21, 2008 10:20 EST