Bond insurer defaults threaten big banks

NEW YORK (Fortune) -- Wall Street banks may inject cash into ACA Financial Guaranty Corporation, which was dramatically downgraded to junk while nearly the entire bond insurance industry was put on negative credit watch by S&P yesterday.

But don't believe for a second that the bailout team of CIBC, Merrill Lynch, and Bear Stearns believe in the company or its business model. They're just trying to avoid another round of extremely damaging write downs on top of the $76 billion in losses that securities firms and banks have posted this year. "The reality, which is clear to Wall Street though obviously not to Washington, is that any such infusion would be a clear attempt to avoid having to recognize losses tied to monoline counterparty exposures," Josh Rosner, managing director at the research firm Graham Fisher, said in a research report issued today.

He adds that the move is the latest in a growing list of strategies banks have used avoid growing economic losses throughout the current economic crisis. The possible ACA bailout is a perfect example of this hypothesis. When ACA's debt went from A to CCC, the move also hit Canadian bank CIBC (which Fortune predicted in November). CIBC said it may immediately write down $1.7 billion of the $3.5 billion in mortgage holdings guaranteed by ACA, which were part of CIBC's roughly $10 billion in hedged collateralized debt obligations.

These CDOs were not included in previous write downs because, though sullied by bad mortgage debt, they were supposedly insured or hedged by entities like ACA. Now that ACA can't backstop the losses, the credit ratings on those bonds will fall, and result in losses.

Merrill Lynch (MER, Fortune 500), one of the biggest banks with exposure to ACA's woes, may have used credit default swap contracts with the insurer's parent company ACA Capital to hedge market risk on $5 billion in CDOs, according to a Nov. 5 analyst report by Lehman's Roger Freeman. If ACA Capital (ACAH) defaults on its contracts, Freeman said Merrill Lynch could immediately take a $3 billion loss. Neither CIBC (CBC) nor Merrill returned calls for comment.

S&P estimates that ACA will need to pay out $2.85 billion on exploding securities, but it only has about a $650 million cushion. Now that its rating has been cut, it is required to post at least $1.7 billion in capital to guard against this threat, and management says it doesn't have the money. So for CIBC or Merrill, which faces nearly $5 billion in losses if ACA craters, why not put money into a $1.7 billion pool split with Bear Stearns that could right the beaten up insurer and improve its rating?

Rosner believes that the strategy breaks down if the underlying mortgages in the bonds deteriorate even more than expected by S&P. Given the past few months of subprime turmoil, exacerbated by the fact that ratings agencies have been asleep at the wheel, it seems a foregone conclusion that the risks will be greater than S&P estimates.

In that case, the monolines would still be underfunded even after their cash injections and "any such infusions would be throwing bad money after good since the monolines would ultimately be downgraded and losses would nonetheless have to be recognized by the counterparties," Rosner writes.

The stakes are very high given that the other big bond insurers are on S&P's negative watch list and that Fitch is in the process of scrutinizing the industry and expected to downgrade. As more bond insurer ratings are cut, banks will have to write down losses on the securities they guaranteed. Bloomberg estimates that an industrywide downgrade would lead to $200 billion in losses. The two biggest guarantors alone, MBIA and Ambac Financial Group, stand behind about $652 billion and $546 billion in debt respectively that could fall in value if those companies are downgraded. S&P estimates that MBIA (MBI) faces $3.1 billion in losses on securities backed by subprime mortgages, that Ambac faces a $1.8 billion loss and Financial Guaranty Insurance Co. could take a $2.2 billion hit.

By virtue of their business model and high credit ratings (until ACA's downgrade they were all among the highest investment grade), none of these companies have the capital to cover these losses. "What's significant about ACA is that it's the first monoline to blow up. There's nothing materially different about Ambac, FGIC, MBIA or XL Capital. They all have the same problem, that they are highly leveraged, have risky exposures and inadequate reserves. It's just a question of degree," says Bill Ackman, founder Pershing Square, a hedge fund that has long been short MBIA and negative on the bond insurance industry.

Banks are exposed to bond insurance problems in other ways. Bear Stearns' merchant banking group owns 29% of ACA Capital. The stock was delisted from the New York Stock Exchange and trades at about 65 cents a share over the counter, down from about $15 this summer. Bear did not return calls for comment.

The monolines are not required to put up collateral when doing business with Wall Street because of their high credit ratings. But that all changed as they started insuring riskier products. ACA and other firms were often required to find counterparties with strong balance sheets to back them up when they insured the exotic bonds that Wall Street became addicted to in recent years.

CIBC, Barclay's and perhaps other banks were willing to be the backstops for a small fee (some believe as little as 5 or 6 basis points). Barclays says its exposure is minimal and has faith that the monolines will meet their obligations.

While a cash infusion to struggling bond insurers may keep downgrades and write downs from happening right now, at the end of the day the bonds, insured or not, are full of worthless paper. Someone will have to pay, whether it be a bank a bond insurer or some other party. "What we're seeing now is a valuation crisis," says Sylvain Raynes, a former Moody's analyst and principal at the structured finance consultancy R&R Consulting. "Wall Street is a big wheel that is moving the same losses in a circle and only postpones the ultimate reckoning and makes it much worse."