ACA Downgrade May Mean Losses For Clients Who Bought HedgesLast update: 12/19/2007 4:37:02 PM
By Lavonne Kuykendall
Of DOW JONES NEWSWIRES
CHICAGO (Dow Jones)--Standard & Poor's steep downgrade of ACA Capital Holdings Inc.'s (ACAH) troubled bond-insurance unit to junk status will have a ripple effect for the companies to whom ACA provides credit protection and hedges and also puts the company's survival in question. The downgrade - 12 notches to CCC, just above default territory - reflects S&P's judgment that the insurer might not have sufficient capital to cover the commitments it has taken on. That is bad news for customers who bought credit protection from the insurer. If ACA can't pay, then the hedges it sold are worthless, and counterparties will have to take the risk - and the losses - back onto their own books. ACA Financial, meantime, will be unable to take on new business as long as potential losses outstrip its available capital. Banks with potential exposure as investors or counterparties include Canadian bank Canadian Imperial Bank of Commerce (CM), Merrill Lynch & Co. (MER) and Bear Stearns Cos. (BSC). "While ACA has been diligently working to address contingent liquidity concerns, it has not focused significantly on raising additional capital," S&P said. "The magnitude of the gap is large enough to create significant doubt that the company could possibly access sufficient hard capital resources to resolve the problem." The ratings company estimated losses on ACA Capital's portfolio could run almost $2.2 billion over the company's Dec. 31, 2007, adjusted capital cushion of $650 million. Sean J. Egan, managing director of independent ratings agency Egan-Jones Ratings Co., estimated ACA would have to raise at least $5 billion over the next couple of days in order to calm investor fears, or "it better find some good bankruptcy attorneys." A spokesman for ACA didn't return a call for comment. Egan said the lack of investor confidence in the bond insurer, which had a recent market value of about $17 million, made it virtually impossible for ACA to come up with that much money. He also called a bailout by large investors unlikely, "for the simple reason that ACA has a huge number of losses coming in the pipeline" of its credit default swap contracts. The New York Times reported Wednesday, citing two people briefed on the matter, that some ACA investors including Merrill Lynch and Bear Stearns might come to the company's rescue with new capital infusions in order to avoid having to write down the value of their investments. Bear Stearns and Merrill Lynch spokesmen declined to comment on whether the banks are considering taking action to bail out ACA. Shares in both banks were trading down more than 1% on the day, when their U.S. investment-bank peers were all higher. A research note from Lehman Brothers analysts in November estimated that, should ACA default, $5 billion of collateralized loan obligations would return to Merrill Lynch's balance sheet, and cause the bank to write down $3 billion. CIBC acknowledged Wednesday that ACA Financial Guaranty Corp. is its counterparty on hedges for $3.5 billion of subprime real-estate exposure and said there is a "reasonably high probability" it will take a large charge against earnings in the quarter ending Jan. 31 as a result. Shares of CIBC fell on the news, and were recently down 1.9% to $71.09. The issue for ACA Financial is that nonprime residential mortgage-backed securities it insured are performing much worse than originally expected, which will likely result in the insurer having to pay off more than expected as the bonds underperform. If it can't cover those payments, then counterparties aren't truly hedged. S&P noted that ACA Financial - alone among the larger bond insurers - faces potential collateral posting requirements. The company - which recently had its shares delisted by the New York Stock Exchange - has previously noted the potential negative implications of an S&P downgrade. In its third-quarter earnings filing with the Securities and Exchange Commission, ACA said a downgrade below A- would trigger contractual requirements that it post collateral to cover the fair value of its credit default swap agreements or be in default. "Based on current fair values, neither the Company nor ACA Financial Guaranty would have the ability to post such collateral or make such termination payments," ACA said in the filing. -By Lavonne Kuykendall, Dow Jones Newswires; 312-750 4141; lavonne.kuykendall@dowjones.com (Monica Gutschi, Kathy Shwiff, Romy Varghese and Stan Rosenberg contributed to this report.) (END) Dow Jones NewswiresDecember 19, 2007 16:37 ET (21:37 GMT)
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