Today the S&P; cut ACA to “CCC” junk, acts on 6 bond insurers.

Standard & Poor’s cut its ratings on ACA Financial Guaranty Corp to junk as part of actions on six bond insurers on Wednesday.

S&P; cut ACA’s rating to “CCC,” or eight levels below investment grade, from “A,” the sixth-highest investment-grade rating. It also said it may cut Financial Guaranty Insurance Co’s ‘AAA’ rating.

Banks Study Bailing Out Struggling Bond Insurer

Officials from Merrill Lynch (MER), Bear Stearns (BSC) and other major banks are in talks to bail out a struggling bond insurance company that has guaranteed $26 billion in mortgage securities, according to two people briefed on the situation, because the insurer’s woes could force the banks to take on billions in losses they had insured against.

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.

My Comment: Not only did it lose its A rating, the rating dropped all the way to CCC

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.

My Comment: The entire US economy is $14 trillion or so in contrast to $42.6 trillion in credit default swaps. The entire Derivatives Trade Soars To Record $681 Trillion.

“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.”

My Comment: There is absolutely no way all the hedges can be paid. Look at the number of derivatives and swaps above as proof.

Investment banks, hedge funds and insurance companies often use credit default swaps to bet on or against bonds without trading the underlying securities. Warren E. Buffett and other critics have described the contracts as financial time bombs, because they say that traders often misprice risk of default and do not set aside enough reserves to cover claims. They also note that investors have become complacent about the risks in recent years because default rates fell to historically low levels.

My Comment: Those time bombs are now going off.

Banks that insured securities with ACA have another reason to keep the company afloat — if it fails they may have to restate earnings they have already booked as a result of their dealings with the company.

My Comment: Those earnings were a mirage. That mirage made the S&P; 500 look cheap. The S&P; 500 was not and is not cheap because much of the earnings were a mirage based on hopelessly unsound financial engineering.

Mr. Egan and other analysts also note that ACA more than doubled its credit default business in the last 12 months; it had contracts outstanding on $70 billion in bonds on Sept. 30, up from $30 billion a year ago. The timely use of credit default swaps this summer helped large investment banks like Goldman Sachs and Lehman Brothers avoid huge losses on mortgage securities as others had billions in losses. But Jim Keegan, a senior vice president and portfolio manager at American Century Investments, questions whether the firms that sold protection will be able to pay up when losses materialize.

“It’s a zero-sum game,” he said, noting that the gains at the investment banks buying the protection have to eventually result in losses for the firms they hedged with. “If you put trades on that worked so well that you bankrupt your counterparty, you will not collect on those trades.”

My Comment: It is obvious here that the emperor has no clothes. There is going to be a global collapse in derivatives as soon as a key counterparty defaults. ACA is one such domino. It remains to be seen if it is THE domino or not.

Last week, the New York Stock Exchange delisted ACA Capital after its stock price had collapsed and the company declined to offer a plan to bring itself back into compliance with listing standards. The stock was trading at about 40 cents over the counter on Tuesday; it traded as high as $15 in the summer.

My Comment: ACA capital was delisted last week, but S&P; kept its credit rating at A up until today. Actions speak louder than words. It is clear the rating agencies are hopelessly and purposely behind the curve.

One look at ACA should be enough to tell anyone that the reaffirmations by the ratings agencies of Ambac (ABK), MBIA (MBI) and others are completely suspect at best, and purposeful manipulation at worst. For more on Ambac and MBIA please see Ambac Blows It … Again.

Here is something I am going to keep repeating until it sinks in: It’s Time To Break Up The Credit Rating Cartel.

Any talk of a bailout of ACA is fantasy. Banks are so capital impaired that a bailout is not possible. If by some sleight of hand shell game they manage to pull it off, they will most likely have to do it again with MBIA and/or Ambac. With that in mind I see MBIA hit a new 52 week low today.

Neither Ambac nor MBIA deserves the AAA ratings they have. However, the ratings agencies do not want to downgrade MBIA and Ambac because it would trigger the re-rating and possible forced sale of $2.5 trillion in municipal bonds.

However, the market will eventually force a downgrade those companies whether anyone likes it or not. Indeed, Professor Depew is reporting Ambac, MBIA: Prognosis Negative in today’s dose of Five Things.

The financial day of reckoning approaches.

Mike “Mish” Shedlock
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