The Next Worry: Bond Insurers

Wall Street is fretting that the subprime carnage could spread to bond insurance firms. A key concern is CDO exposure

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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 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).

Stock Tailspin

But a flurry of downgrades on mortgage-backed securities and CDOs has started to affect insurers' earnings. Anxiety has focused on ACA Capital (ACA), 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 BASE capital. The company claims it has $1 billion in capital it could use 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."

MBIA's Troubles

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.