My thought for the day: The credit crisis is like an onion: every time you peel back another layer, you want to cry.
After reading it, I'm betting that a lot of people are going to ask themselves one question: "Why are we bailing out Wall Street?"
Wall Street used ACA to hide loads of subprime risk. It worked—until the tiny company collapsed
Here's another secret behind the mortgage mess: It turns out that Wall Street generally didn't buy insurance on subprime bonds to protect against default. Instead, many big banks used the policies to play one set of accounting rules against another.
The results of the game were bigger profits for banks, more money to continue cranking out securities built on risky subprime mortgages, and far less clarity about the banks' true exposure to the toxic investments. The mess left by insurer ACA Financial Guaranty (ACAH), which collapsed in December, is now revealing just how critical the bond insurers' role was in the mortgage market. In essence, ACA and the rest of the industry helped spur the boom to new heights, extending it far beyond its natural end point.
For years the bond insurers operated in relative obscurity. They mostly sold guarantees on basic municipal debt, paying out claims in the rare case a bond defaulted. But as competition increased, companies moved into more exotic products with bigger profits, including the risky securities known as collateralized debt obligations that invested in subprime loans and other assets. ACA—the fledgling outfit that got a new lease on life back in 2004 from an investment by Bear Stearns—took it to extremes. By 2007 CDOs and other types of exotic securities accounted for 90% of its portfolio, compared with 36% for MBIA, the nation's largest bond insurer.
With such an outsize exposure to hazardous debt, tiny ACA has become a focal point for the frenzy surrounding the bond insurers, which together guaranteed more than $800 billion in complex securities, including subprime assets. ACA's implosion in December sent shock waves across the market and forced big banks to take $6billion in losses. Regulators, in turn, feared that other insurers would suffer similar fates, triggering more losses and aggravating the credit crunch.
MASKING THE ODOR
Today, ACA lies in ruins, its business under the watch of Maryland state insurance regulators. But the story of its rise and fall sheds much light on a little-known industry that continues to cause concern among regulators, investors, and rating agencies. A BusinessWeek analysis reveals the insurers' guarantees turned out to be little more than a subprime shell game, one that has prompted at least one lawsuit so far. ACA declined to comment.
Initially, the insurance promoted confidence among regulators. The deals appeared to be another way to spread the risk that borrowers would default on the underlying mortgages. It was the sort of rationalization that encouraged a host of bad lending decisions all along the mortgage food chain. "If the insurers weren't there, you would have questioned (CDOs) a lot more," says Nicolas Vassalli, managing director at hedge fund firm Structured Portfolio Management.
In retrospect, the bond policies only masked the inevitable subprime stink, until it became too overwhelming by late 2007. In November, ACA's parent company reported $1billion in losses for the third quarter. Standard & Poor's (MHC) put the insurer under review, slashing its credit rating from A to CCC a month later. The downgrade forced the insurer to come up with more collateral to show it could pay potential claims, under the terms of its agreements with banks.
