Death of a Bond Insurer

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

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Overall, the deals boosted banks' profits and reduced the amount of capital they had to set aside on their books for the securities. That freed up money for banks to funnel back into subprime securities. Merrill, which churned out more CDOs than any other Wall Street firm during the last two years of the boom, was a big ACA client. "It's another example of the moral hazard that people behave differently when they have insurance," says Frank Partnoy, a former Wall Street derivatives trader who is now a professor at the University of San Diego School of Law. "The banks kept making CDOs because they had the ability to hedge with insurance."

As players like Merrill rushed to do deals in the final months of the mortgage binge, they began to take out multiple insurance policies from different vendors for the same CDO pool. For example, according to industry sources, Merrill purchased guarantees in 2007 from both MBIA and ACA on pieces of a $1.5billion CDO called Forge ABS High Grade I, one of Merrill biggest's deals. At least seven other Merrill CDOs from that year were insured by different companies.

In doing so, Merrill and other banks created yet another set of entanglements, giving an increasing number of players a stake in the fate of a single CDO. Those interconnected relationships are the subject of recent lawsuits between Merrill Lynch and another bond insurer the bank used, Security Capital Assurance. "Merrill Lynch aggressively marketed [pieces of its] CDOs up and down Wall Street...desperate to get these off its books," the insurer says in a Mar. 31 counterclaim. The suit also quotes an e-mail from a Merrill salesperson that calls the insurance "a very nice deal and a big help to [Merrill]." Merrill, which is suing SCA over a contract dispute, says the counterclaim is without merit and "makes assumptions that are very simply wrong."

"RISK-FREE BUSINESS"

The insurance deals made everyone happy at first. Fees from the complex investments ran high for risks that seemed remote. The debt ACA guaranteed was the cream of the crop, with top-quality, AAA ratings that signaled the bonds would rarely, if ever, stop making payments. In fact, the bonds were designed to make their regular interest payments even if the underlying loans lost 30% to 50% of their value. "Most people saw this as a risk-free business," says Christopher Whalen, managing director of consultancy Institutional Risk Analytics.

ACA ramped up its coverage of CDOs to the very end. It was practically the only type of insurance the firm sold in 2006; that year, ACA wrote $25 billion of coverage on CDOs, compared with $1 billion on munis. Nearly a third of its total CDO portfolio had the taint of subprime.

When the credit market began to retreat, ACA charged ahead. In the first six months of 2007, ACA wrote $22billion of insurance on CDOs, nearly double the amount in the same period a year earlier. Roseman remained undaunted, even after the bankruptcy of two Bear Stearns hedge funds sparked a global credit crisis last summer: "We're looking pretty positively on structured credit throughout the remainder of the year," Roseman said in an Aug. 1 conference call. "Pricing opportunities have expanded dramatically."

But as mortgage delinquencies mounted, the accounting arbitrage began to grow poisonous for ACA. By insurance industry standards, ACA showed a $20 million gain in the first half of 2007 as well as the third quarter of that year. The earnings statements of ACA's parent company, which reports to shareholders under GAAP, told an entirely different story. Those losses hit $82 million in the first half and totaled $1 billion in the third quarter.

The last remnants of the accounting illusion vanished on Dec. 19. That day, nearly a year after the housing downturn began, S&P cut ACA's credit rating. The losses from subprime securities, which once seemed to be only market gyrations, had become inevitable by S&P's standards. The insurer is currently on life support, alive only through the concessions of its clients, who have not enforced the terms of the deals and forced the insurer to cough up more money. The banks have given ACA a reprieve through Apr. 23 while they reassess whether to pull the plug.

Henry is a senior writer at BusinessWeek. Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.