Credit Rating Downgrade of ACA Financial Could Reverberate Across Market

Standard & Poor's credit-rating downgrade of the small bond insurer ACA Financial Guaranty Corp. could negatively reverberate across Wall Street, as billions of dollars of guarantees made by the insurer may become effectively worthless. 
 
On Wednesday, S&P cut its A credit rating on ACA to the deep junk rating of CCC, a heavy blow for the financial guarantor, which depends on a sound credit standing for access to capital and to get business. S&P said it had "significant doubt" that the company can come up with the capital needed to resolve its problems. The company said that it was working to stabilize its finances. 
 
ACA insures the interest and principal payments on bonds, committing to pay investors if a bond issuer defaults. Initially this business was tied to the stable municipal-bond market. But, in the past few years, ACA wrote insurance on more than $60 billion of securities backed by mortgages and corporate debt. A big chunk of these were known as collateralized debt obligations, or CDOs, that pooled risky subprime bonds, whose value has deteriorated substantially in recent months. 
 
Many buyers of this insurance were large financial firms and banks -- including Merrill Lynch & Co., Canadian Imperial Bank of Commerce and others -- that are now potentially exposed to additional losses. CIBC warned it may have to take up to a $2 billion charge on its CDO holdings insured by ACA, prompting Fitch Ratings to place the Canadian bank's own AA-minus credit rating on review for a downgrade. 
 
Firms that bought insurance from ACA may have to shoulder losses on insured bonds. This highlights another market problem: counterparty risk. Many might find themselves exposed not only to bad bonds but also to shaky trading partners. 
 
With the downgrade, ACA may soon be forced to pony up cash or collateral against some of its guarantees, a move that could render it insolvent. S&P said the company's capital cushion of $650 million was insufficient to cover estimated expected losses of more than $2 billion. That means it faces intense pressure to raise capital in an inhospitable environment. 
 
In a statement, ACA said it has entered into a forbearance agreement with its counterparties that will help it avoid defaulting on its guarantees until Jan. 18. It said it was surprised at the magnitude of S&P's downgrade, and planned to work with its counterparties to find "a more permanent solution to stabilize its liquidity and capital position." 
 
"The future looks tenuous for ACA; it's hard to see how they will make it through this without outside help," said David Havens, an analyst at UBS Securities. 
 
Investors and analysts had been bracing for the ACA downgrade for weeks. Still, it was unclear exactly how the sharp downgrade will affect the financial institutions that bought credit guarantees from the insurer. 
 
S&P also adjusted its views on several other bond insurers that are better capitalized than ACA but are also facing potential losses from mortgage CDOs. The rating company said it has a negative outlook on financial guaranty units of Ambac Financial Group Inc., MBIA [TEXT]Insurance Corp., and XL Capital Assurance Inc., which all still have their top AAA ratings. It is reviewing the AAA rating of Financial Guaranty Insurance Co. for a possible downgrade. Over the past few days, Moody's Investors Service and Fitch also took a more bearish view on some bond insurers.