Over an Insurance Barrel

By Steven Pearlstein
Friday, January 25, 2008

Imagine that you buy a house with mostly borrowed money -- a mortgage -- and the lender insists that you take out fire insurance to protect your house and his collateral.

You could purchase the insurance from a top-rated insurer, like Fireman's Fund, but you decide to go instead with Good Enough Guarantee, which is able to offer you a slightly lower premium because it has a lower credit rating and isn't required to set aside as much money in reserve to cover potential claims.

At first, it works out well for everyone. The lower premiums mean you have more money to spend on home furnishings. Good Enough's business begins to boom. Because of its willingness to write insurance in areas prone to brush fires, it wins lots of new business, particularly from developers in the area who are also shareholders in the insurance company. And because it has less of its own money tied up in reserves, its returns are among the best in the business.

Anyway, you know what comes next. There's a drought, lots of brush fires, and part of your house is destroyed. Only then do you find out that Good Enough has been hit with so many claims that it has enough money to cover only a quarter of the claims that have come in.

In simple terms, that's pretty much the dilemma facing some of the biggest players in global finance as they try to collect on the insurance they bought on $66 billion of complex securities from a company that turns out to have only about $425 million in free capital.

The company is ACA Financial Guaranty, a once-sleepy and nicely profitable municipal bond insurer that was spun off from Baltimore's former insurance giant, USF&G. In 2001, ACA decided to get into the hot new area of "collateralized debt obligations" -- pieces of loans that are repackaged and sold off to large investors. ACA would make money by first creating the CDO packages and selling them off in pieces to large investors. And it would collect premiums by offering the investors insurance to protect them in case any of the underlying loans went bad.

At first, the packages mostly involved loans to big corporations, including Enron and WorldCom. But by 2005, ACA was heavily into buying up and repackaging mortgage loans that were originally assembled by Wall Street investment houses such as Merrill Lynch and Lehman Brothers, along with Bear Stearns, which owned more than a quarter of ACA stock. And because ACA, with an A rating, was insuring securities that carried a more solid AAA rating, it was allowed to put aside less than half the reserves as its AAA competitors.

It worked like a charm until last summer, when the subprime crisis hit and the rating agencies began to strip the CDOs of their AAA ratings. Those downgrades forced ACA to take a $1.6 billion write-down on its books, reducing its book value to below zero. As the business began to unravel, Standard & Poor's lowered the credit rating for ACA from single A to CCC, which under the terms of its insurance contracts, known as "credit default swaps," requires it to come up with $1.7 billion in collateral that it doesn't have.

Moreover, because ACA's ability to make good on its insurance policies is now in doubt, banks and other financial institutions have been required to take billions of dollars in markdowns on their CDO holdings. These include the very same Merrill, Lehman and Bear Stearns, along with Citigroup, UBS, CIBC, Credit Agricole and Societe Generale. And there still are two dozen other holders of ACA-insured CDOs yet to come clean.

Unfortunately, ACA isn't the only bond insurer to have answered the siren call of the CDO and now find itself in the soup. Its larger rivals, MBIA and Ambac, have taken a combined $8.5 billion in write-offs on the value of their credit-default swaps and are in danger of losing their triple-A ratings. Should that happen, many of the same banks already nicked by ACA could be forced to take additional write-downs on their CDO holdings while causing other investors to dump their CDOs onto a depressed market at fire sale prices.

All of which explains why the insurance commissioners of Maryland (ACA) and New York (MBIA and Ambac), working behind the scenes with the Federal Reserve and Treasury, are scrambling to find some way to rescue the insurers and spare the already-fragile global financial system from another shock.

There has been some interest on the part of private-equity firms, and "vulture" investors like Wilbur Ross, who might want to buy all or part of the insurers. The New York state insurance commissioner has asked a number of the banks that have the most to lose if the insurers collapse to consider participating in a refinancing plan that could reach $15 billion -- a prospect that sent stock prices soaring Wednesday when news first leaked.

How would that work? No doubt it would be complicated, and the details have yet to be worked out. But, for our purposes, think of it in terms of the homeowner in the fire insurance analogy:

You've just suffered major damage to the house. You file a claim. Suddenly the insurance commissioner shows up at the house, informs you that the insurer is broke and suggests that if you want to get your claim paid, you'll have to lend it the money or invest in the company.

"And why would I throw good money after bad?" you ask. "Because if you don't," he replies, "you'll collect very little on your claim, you won't have any insurance on what remains, the value of your property will plummet and your mortgage company will most likely foreclose.

"In other words, it's a deal you can't refuse."

Steven Pearlstein can be reached atpearlsteins@washpost.com.

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