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Credit Crunch April 3, 2008, 5:00PM EST

Death of a Bond Insurer

(page 2 of 3)

Under ex­CEO O'Neal, Merrill churned out CDOs, insuring many with ACA Doug Mills/The New York Times/Redux

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What's more, Wall Street may face a fresh round of losses. That's because ACA also insured $43 billion worth of securities backed by risky corporate loans and bonds, like the ones used to fund the flurry of buyouts in recent years. Those investments could be the next in line to sour, a turn made more likely by the weak state of the economy. If those securities go bad, banks would have to take more writedowns, squeezing the credit markets even further.

NURSING HOMES AND CASINOS

ACA barely figured on the financial scene four years ago. The company, which was called American Capital Access when it was founded in 1997 by a former executive of credit-rating agency Fitch Ratings, searched in vain for a profitable niche. For years ACA largely wrote insurance on low-rated municipal bonds for projects like nursing homes and Native American casinos.

After taking losses from troubled mobile home bonds, it scrambled to raise more capital through an initial public offering in 2004. But the insurer had to abort the plan when it came to light that then-CEO Michael Satz had a lingering personal income tax issue from a previous job. Bear Stearns seized on the opportunity, stepping in to buy roughly one-third of the insurer for $105 million. The bank then installed one of its own executives as chairman and hired Alan S. Roseman, a bond insurance veteran, as chief. Almost immediately, Roseman began to push ACA into CDO insurance, an area his predecessor, Satz, had only begun to explore.

Why would banks buy insurance on AAA securities, especially from ACA, which had only an A rating? That would be akin to homeowners at the top of the hill purchasing flood insurance from a company at the side of a river. If a flood did happen, the insurer wouldn't be around to pay any claims.

The explanation lies in the complexities of accounting rules. Both banks and insurance companies report earnings to investors under what's known as generally accepted accounting principles (GAAP). But insurers also follow another set of guidelines, used by state insurance regulators and applied in key areas by credit-rating agencies.

In the case of CDO insurance—technically called credit default swaps—part of the appeal lies in the differences between the two accounting regimes. GAAP tends to require companies to value securities at prices in the market. Under those so-called mark-to-market rules, banks have to report losses on the investments each quarter even if they're only on paper. Insurance rules, by comparison, make firms only declare losses if it looks as if the bond is permanently damaged and they'll have to pay a claim.

Insurance turned out to be a sort of accounting arbitrage, allowing banks to take advantage of that different set of rules. By using it, they could offload the price risk to insurers' books to avoid suffering a hit to earnings if the bonds dropped in value. "Bond insurance was an accounting strategy," says former ACA chief Satz, now the founder of an online startup called BarterQuest. "It reduced banks' mark-to-market worries."

Insurance offered banks another advantage: It allowed them to execute what's known as a negative-basis trade, a strategy that essentially lets banks book profits on CDOs up front, even though they haven't collected the money yet and might never do so.

Here's how it worked: Say a bank bought a security that paid an interest rate that was 0.5 percentage points above a benchmark rate. Then it went out and purchased insurance on the bond that cost 0.2 percentage points above a benchmark rate. After doing so, the bank could book the difference between the interest payments and the insurance premiums, the 0.3-point spread, across the life of the bond—usually 5 to 10 years. Banks recorded those illusory profits in the quarter they took out the insurance.

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