Calculated Risk: Banks Studying Bailout of ACA

ACA, which insures $26 billion in bonds is insolvent, and the banks are looking at bailing it out. Bailing out an insolvent company generally makes no sense, but if they don’t then the banks have to record the non-uninsured bonds on their balance sheets.

Then we have MBIA, the largest bond insurer in the world, being threatened with a downgrade by Fitch, if it does not rais $1 billion in cash in the next 4-6 weeks.

While these companies in and of themselves are not very large, the consequences are staggering:

The insurer, ACA Capital Holdings, which lost $1 billion in the most recent quarter, has been warned by Standard & Poor’s that its financial guarantor subsidiary may soon lose its crucial A rating. If it did, the banks that insured securities with the ACA Financial Guaranty Corporation would have to take back billions in losses from the insurer under the terms of the credit protection they bought from the company.

The troubles at ACA could also serve as the first real test for credit default swaps, the tradable insurance contracts used by investors to protect, or hedge, against default on bonds. In June, the value of bonds underlying credit default swaps rose to $42.6 trillion, up from just $6.4 trillion at the end of 2004, according to the Bank for International Settlements.

“The hedge is only as good as the counterparty, or the other party, to the hedge,” said Joseph R. Mason, a finance professor at Drexel University and the Wharton School of the University of Pennsylvania. “This is part and parcel of the financial innovation that has grown very rapidly in recent years.”

In other words, phony money and real debt.

If MBIA loses its AAA ratings, more than $2 TRILLION in securities would lose its AAA ratings too.

We are still on the downslope of this collapse, so it has got a ways to go before we turn a corner.