So Much For Being Hedged

One of the most underappreciated threats associated with globalization, financial innovation, and the unintended consequences of government "safety nets" (and other such policies) is a generalized increase in counterparty risk.

Whether they realize it or not, individuals and firms now have all sorts of direct, indirect, hidden, layered, ambiguous and otherwise questionable relationships with others that may prove debilitating or even fatal in the event of a sustained economic downturn or a serious disruption in the financial system.

One case in point stems from those many financial institutions who, either unwittingly or not, entered into risk-shifting agreements with counterparties that eventually turn out to be worth less than the paper they are printed on.

Under those circumstances, bankers who took on extra risk because they assumed other exposure on their books had been laid off elsewhere could find they are stuck between a rock and a hard place when that "hedge" turns out to be illusory and they are suddenly left twice as exposed as they thought they were -- most likely, at the worst possible time.

In "ACA’s Downgrade Threat Could Leave CDS Counterparties Without Recourse," Debtwire details how problems at one relatively small bond insurer could turn out to be yet one more bit of bad news for firms that already have plenty to go around.

ACA Financial Guaranty could default on insurance agreements if Standard and Poor’s chooses to downgrade the bond insurer’s rating, a credit derivatives lawyer and a market participant told Debtwire. Late on Friday S&P placed ACA’s rating on negative watch.

In total, ACA Financial insures USD 69bn of asset backed and corporate bonds for 31 counterparties through the use of credit default swap contracts, according to SEC filings. Those contracts include coverage of USD 25.7bn in AAA rated ABS CDO notes backed by subprime RMBS [Residential Mortgage-Backed Securities], many of which are held on the balance sheets of investment banks.

Citigroup has USD 43bn in exposure to super senior ABS CDO notes, while Morgan Stanley has USD 8.3bn in exposure, according to the companies. Merrill Lynch has USD 14.2bn in ABS CDO super senior exposure.

Because ACA Financial is rated A – well below the industry norm of AAA – its CDO CDS contracts contain a provision requiring it to post collateral in the event of a downgrade, said the market participant. Such provisions require ACA to post cash equivalent to the mark-to-market loss of the CDS contract pursuant to a ratings cut.

In the event of a downgrade by S&P, ACA Financial would become insolvent, confirmed company Treasurer Alex Willkomm. But, he added, S&P affirmed ACA’s rating as recently as 31 October.

In addition to the structured credit insurance, ACA Financial insures roughly USD 700m par value of municipal bonds, according to SEC documents. The insurance business is a division of publicly listed ACA Capital, which also issues CDOs and reported USD 18bn of assets under management as of 30 September.

But ACA Financial is bankruptcy remote, leaving the counterparties on its CDS contracts with little recourse to recoup losses if the CDS contracts were not transferred to another party, said the lawyer. So far, S&P has downgraded very few of the super senior CDO bonds that ACA Financial insures, but if that changes, the company’s capital cushion needed to maintain its A rating could be compromised, according to Credit Suisse.

The market value decline of the CDS contracts could force ACA Financial to post USD 1.7bn in such a scenario, based on the insurer’s mark down of the market value of its CDO contracts to 93% of face value as of 30 September, confirmed a company spokesperson.

However, AAA rated subprime CDOs currently trade from the high single digits on junior tranches to 60% of face on super senior tranches, according to a sellsider and a buysider. Almost all of the CDOs ACA Financial insures are super senior, according to its recent 10-Q. If S&P, which is the only agency to rate ACA, slashes its rating, markdowns of 40% could translate to payouts on insurance contracts exceeding USD 10bn - roughly 10 times the company’s ability to pay.

Merrill Lynch in the third quarter discounted its own super senior ABS CDO holdings by an average 19%, while mezzanine AAA notes were written down by 37%.

ACA Financial’s credit rating most immediately hinges on the ratings of the AAA rated CDO notes it insures. To date, ratings of only USD 33m of AAA rated notes insured by ACA have fallen to AA. S&P would need to downgrade an additional USD 5bn–USD 10bn of CDO notes to place pressure on ACA’s rating, according to Credit Suisse.

The more downgrades, the more capital ACA must have on hand to act as a cushion and maintain its A rating. S&P only takes into account its own CDO ratings for the exercise.

“There is no consequential level of capital that has been consumed by the downgrades. Will that change over time? It may. But it is hard to tell what that may be,” said Alex Roseman, president and chief executive of ACA during the company’s 3Q earnings call today.

ACA’s shares closed at USD 2.93 yesterday, up USD 0.23 from Wednesday but down 63% from a recent high of USD 8 in August.

ACA has only USD 1.1bn in claims paying resources, according to research by Credit Suisse. Assuming the contracts were not transferred to another counterparty, the existing contract counterparties would become unsecured creditors in the event of a bankruptcy, said the lawyer.

Should ACA Financial default on its CDS contracts, “The eventual fallout will be felt by some very large players,” said a buyside source.

Investment banks that underwrite CDOs typically retain the super senior tranches and offset that risk by entering CDS contracts with insurers like ACA, said a sellside trader.

The hedge allows the banks to collect the negative basis between the interest rate on the bonds and the cost of the CDS. A bankruptcy filing by ACA would render those contracts worthless, and leave the write-down plagued banks with even more subprime exposure on their books, the buyside source said.

Collateral posting requirements in CDS trades are typically reserved for lower credit quality counterparties in order to ensure payments are made. Because other monoline mortgage insurers – such as MBIA Insurance Corp., Ambac Assurance Corp. and Radian Asset Assurance – are AA and AAA rated, their CDS contracts are unlikely to include the provisions, said the market participant.

“In the case of ACA, it is widely accepted in the market that there is a downgrade provision,” said the market participant.

ACA needs a 0.8x margin of safety to maintain its A rating, according to S&P. If all of its RMBS CDO exposure were downgraded to AA, its margin would fall to 1.1x-1.4x; if it fell to A, the company’s margin would be 0.9x-1x, according to Roseman.

Credit Suisse estimates ACA’s current solvency margin at 1.2x-1.3x. If USD 15bn of ACA’s USD 69bn of CDS exposure was downgraded to BBB from AAA – blowing the insurers capital charge to 1% from 10bps – it would be entirely tapped out of excess capital, according to Credit Suisse.

Comments

[George Weinbaum]

I've been saying these things for years. Excellent post. The idiot banks thought they could "lay off the risk", so they took on even more risk. Amazing but true.

[Sackerson]

Michael, I'm not that technical, but I get your general point. You're giving us a timely warning, seeing how some ordinary individuals are now getting worried and looking how to secure their pension funds with warrants. And presumably the risk will be expensively re-priced when things get worse.

But since we have past events to learn from, surely history won't repeat itself exactly. I'm sure everybody is keen to avoid a late-20s-style US deflation, and also a Germany-1923-type hyperinflation. What do you consider is the MOST LIKELY course of events from here, rather than the worst-case?

[Bob Ely]

Ownership of ACA:
27.7% Bear Stearns
13.3% Stephens
12.6% Third Avenue Trust
11.0% Chestnut Hill
10.4% Perry Capital (up from 5.5% in 14A)

[Economic Crisis]

With apologies to The Graduate, "Young man, I have one word for you: collinearity."

[Tuesday St. James]

The author may be making some prescient points -however, he neglected to mention that the CDS sold by ACA do not require payments in the event the related CDOS are downgraded, or when there is a loss in market value. Payments on CDS (other than Contingent CDS, which are a whole 'nother story) are required when there is an actual cash loss. Therefore, like Mark Twain's death, the rumour of the demise of ACA and its ilk are greatly exaggerated.