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Dissecting the ACA Downgrade


S&P shook the Street when it reassessed the bond insurer. Critics say it should have done so sooner

The collapse of ACA Financial Guaranty late last year was one of the more jarring moments of the mortgage meltdown. The trigger: a downgrade of the bond insurer by Standard & Poor's.

For years, S&P, the only credit-rating agency to follow ACA, bestowed a high-quality A rating on the insurer. Then, on Dec. 19, the agency cut ACA's grade from A to CCC overnight, a rare move for S&P. "When [we] had enough information to determine that the performance of subprime mortgages was diverging significantly from our earlier assumptions, we took action," S&P said in a written statement. (S&P, like BusinessWeek, is owned by McGraw-Hill.)

The dramatic downgrade has reverberated throughout Wall Street. When ACA's rating dropped to junk, it had to come up with extra money to show that it could pay potential claims, in accordance with the terms of its insurance deals with big banks. But ACA, which guarantees complex securities like those tied to subprime mortgages, didn't have the funds. ACA then failed to comply with its agreements, forcing Merrill Lynch (MER), CIBC, and others to take $6billion in writedowns. Markets and regulators, in turn, worried over fears that more bond insurers would fall.

The episode came at a sensitive time for S&P and other rating agencies, such as Moody's Investors Service (MCO) and Fitch Ratings. Amid the subprime fallout, the industry has had to defend its scoring system to critics. Among them: politicians and regulators in the U.S. and Europe who believe the agencies were too slow to recognize the deteriorating housing market and incorporate the resulting losses into their models.

Before the downgrade, S&P's opinion on ACA diverged from the stock market's. Shares of the insurer's parent company, ACA Capital Holdings (ACAH), which started sliding in June, had dropped 95%, to 50 cents, by the time the rating was cut in December. ACA's financial results also painted a picture of weakness. The company reported a $1 billion loss in the third quarter, driven by markdowns in the prices of the risky securities it had insured. "There were lots of reasons to demand more due diligence on ACA earlier in the ratings process," says Janet Tavakoli, president of consultancy Tavakoli Structured Finance and a longtime critic of the rating agencies.

"LESS THAN CREDIBLE"

S&P, like its peers, doesn't usually factor market prices into its decisions. The agency long has said those prices can reflect short-term gyrations and not necessarily a company's true financial position. "[Ratings] are designed to be stable, and unlike market prices, they do not fluctuate on the basis of sentiment," S&P wrote on Nov. 7, in response to an inquiry by Britain's Parliament into the agencies' role in the credit crisis.

On the subject of bond insurers, S&P argued in late October that the losses on the earnings statements were overstated since they were based on "less-than-credible" market prices for the products that the industry insured. The real claims insurers would have to pay on the bonds, the rating agency said, would be far lower. The market prices "may not be predictive of actual losses," S&P said in an Oct. 31 report. "Trading for these assets is often sporadic and at prices that assume a worst-case scenario."

What prompted S&P to change its mind about ACA after sticking to the A rating for months? The answer lies, in part, in how S&P assessed ACA's health. As part of its rating decisions, S&P calculates insurers' anticipated losses based on historical trends. S&P then tweaks that formula depending on how it thinks the current environment deviates from those patterns. Until late last year, the rating agency had adjusted its models only to account for mounting damage to subprime securities created in 2006.

When S&P took a fresh look at ACA and the insurers in December, it included the rising losses from other types of assets for the first time. Among them: subprime investments from 2005 and 2007, big areas of business for ACA. Factoring in the new data and falling home prices, S&P said ACA would lose $4.2 billion, 10 times the agency's estimate from the summer. S&P promptly cut ACA to junk, aligning its opinion with the market. Says S&P Managing Director Dick P. Smith: "Throughout the fall, as more information about the performance of mortgage-backed securities from 2005 through 2007 became available, we placed ACA on [review] and subsequently downgraded it, signaling our concerns about its credit quality."

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

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