The Next Worry: Bond Insurers

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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."

Low Yields, Tricky Valuations

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 write-downs 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.

ACA: Why It's Vulnerable

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 ontheir balance sheets, promptingfurther writedowns.

ACA won't reveal its clients, but one is Bear Stearns (BSCC), 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.
With David Henry.